UK government bonds are cheaper than US treasuries despite a slightly higher US base rate. What does this mean for investors?
- Gilts of two-plus years are trading cheap to US treasuries, despite a slightly higher US base rate
- With the UK facing unique inflationary pressures it is unlikely to support longer-term rates as high as in the US, contradicting market pricing
- Either the long-run neutral rate has shifted or inflationary issues will persist for several years – providing an opportunity in government bonds
The UK and the wider world have endured many common inflationary woes. This has included surging energy and food prices following the invasion of Ukraine and Covid-induced supply chain bottlenecks pushing up the cost of input prices and final products alike. But the UK’s fight against inflation has been made more challenging by country-specific problems:
- A strained NHS with record waiting times for treatment Since December 2019 this is contributing to an additional 412,000 adults out of the workforce due to long-term sickness1 – 1.25% of the UK’s employed population. Additionally, one in six of the UK’s workforce report that they suffer from long-term health problems, which reduces productivity and hours worked2
- Being one of the largest net importers of food and drink This leaves the UK particularly exposed to rising global food prices3.
- Brexit-induced labour shortages As of November 2022, 13.3% of businesses reported a shortage of workers, with a high proportion of sectors such as transportation and education citing a lack of EU applicants as the reason they are unable to fill vacancies4.
Market expectations
- 1-year rates at 5% in a year’s time
- 1-year rates at 4.5% in three years’ time
- 1-year rates at 4.8% in five years’ time
This is relative to one-year gilts trading at less than 1% from the financial crisis to 2022. This may reflect expectations of higher inflation for longer and would be contrary to recent Bank of England (BoE) guidance that inflation will be at 2% by early 20257.
Looking at implied pricing for the US yield curve8 we get:
- 1-year rates at 4.5% in one year’s time
- 1-year rates at 3.9% in three years’ time
- 1-year rates at 4.2% in five years’ time
Where will rates go?
The theoretical answer is the neutral rate. This is the rate at which monetary policy is neither accommodative nor restrictive, a short-term rate consistent with the economy maintaining full employment with associated price stability. To get to this rate we would need inflation under control. The Fed sees the long-run neutral rate at 2.5%. Between 2016 and 2020 the UK largely had both full employment and inflation close to target but had a base rate of between 0.25% and 0.75% (Figure 1).
Figure 1: recent history of UK CPI and BoE base rate
Source: Bloomberg, as at 30 June 2023
Labour force
While US and UK birth rates have recently converged (Figure 2), if we look at the period spanning 2005-09 the US birth rate was running at 13% above the UK. This means that from 2023-28, when this cohort turns 18, the US will have a greater boost to its home-grown labour force.
Figure 2: UK and US births per year per 1,000
Source: Our World in Data, as at January 2022
Labour productivity
Figure 3: US and UK gross fixed capital formation (% of GDP)
Source: https://data.worldbank.org/indicator/NE.GDI.FTOT.ZS?locations=US-GB
Conclusion
In conclusion, while the UK faces unique inflationary pressures and negative technicals factors, longer-run headwinds to relative GDP growth will likely mean the UK economy cannot support interest rates as high as the US in the longer term. This contradicts market pricing, indicating UK yields should be lower than that of the US in the longer term.
Market pricing in the US and UK suggests that either the long-run neutral rate has shifted dramatically or that current inflationary issues will persist five years into the future, which represents an opportunity in government bonds.
