David Roberts

Plan B only makes government bonds more overvalued

David Roberts

With Boris Johnson announcing his “plan B” to ward off Omicron, or deflect attention from matters at Number 10, UK bonds have risen and the currency fallen in anticipation of a delay to rate hikes from the Bank of England.

One reason cited for a potential delay is that the economy would need further support from “cheap money”. Whilst there is economic validity to that, it is worth noting just how cheap money already is from the perspective of HM Treasury, the paymaster of the Bank of England.

Of course, what is cheap for the Treasury is expensive in the extreme for those lending to her. The near 10% plunge in value in the first quarter of 2020 has all but been all but forgotten as government bonds have rallied in recent months. An investment strategy built around owning them is just an accident waiting to happen.

Inflation stands at multi decade highs and is set to move upward in early 2022. That erodes the purchasing power of bonds. And even before we adjust for inflation, those bonds are already at very expensive levels. For example, investors are only paid about 0.7% per annum to lend to the UK Government for 10 years. That compares with nearly 1.5% in the US or looking further afield 2.5% in New Zealand.

In normal times, investors expect to be compensated for inflation. Indeed, over the past 40 years, investors in gilts have been paid a yield on average 2.2% above inflation. Today, those investors are paid a record low of 3.5% below inflation and some 5.7% below the norm since 1990.

While the short-term outlook for the gilt market is shrouded in Omicron mystery, one thing we can say with a great deal of confidence is that there is very little long-term value on offer here. We have taken a contrarian, very low-duration position as we await the market realisation that inflation is here to stay. If and when this happens, we expect to uncover lots of alpha investment opportunities.

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Friday, December 10, 2021, 9:43 AM