Understanding Bond Yields: Why They've Hit a 25-Year High in the UK

Introduction:

Let's dive into the world of government-issued treasury bonds and their recent trends. These bonds come with a specific interest rate, tied to a fixed value. Investors purchase these bonds, and the government uses the funds to finance its various expenditures. As it's essentially a loan, the government pays back the investors along with interest, which is referred to as the yield.

 

For example, consider a 5% bond issued for £100. This means the investor earns £5 in interest. Now, if the government later issues a bond at a higher rate, say 6% for £100 (£6 interest), the value of the initial 5% (£5) bond decreases. This is why when bond prices drop, the yield goes up, and vice versa.

 

Currently, UK treasury yields are on the rise because investors are looking to sell UK government bonds. The reduced demand causes bond prices to fall.

This trend isn't exclusive to the UK; it's happening globally. Even in the United States, bond yields recently reached a 16-year high.

 

Why is this happening now?

 

This scenario revolves around two central banks navigating challenging economic conditions. In September, both the Bank of England and the Federal Reserve decided not to increase their main interest rates, which stand at 5.25% and 5.5%, respectively. These decisions, along with the economic positions of each country, are driving changes in the bond market.

 

To put things in perspective, the UK currently faces a headline inflation rate of 6.7% (6.2% for core inflation, excluding volatile items like energy), with a GDP growth rate of 0.6%. In contrast, the United States has a lower inflation rate of 3.7% (4.3% for core inflation) and a stronger GDP growth rate of 2.4%. These economic disparities influence expectations in the financial markets regarding what the central banks might do with interest rates next.

 

Before the Bank of England's recent decision, there was a general expectation that UK rates would rise to 5.5%. However, a lower-than-expected inflation rate announced just days before the bank's rate decision led to the decision to maintain rates. Furthermore, the Bank of England indicated that it did not anticipate another rate hike, foreseeing stability at 5.25%.

 

On the other hand, the Federal Reserve's decision to hold rates in September was seen as a temporary pause, with expectations of future rate hikes in the United States.

 

What does this have to do with bond yields?

 

Anticipated rate hikes in the United States have caused investors to shy away from holding US bonds, as their values will decrease. As new bonds are issued at higher yields to match the central bank's interest rate decisions, existing bonds with lower yields lose favor among investors.

 

A similar situation is unfolding with UK bonds. Since US bonds will soon offer higher yields, investors are reallocating their portfolios towards the US, where they can earn better returns.

 

These changes also have implications for the value of the British pound. Following the Bank of England's decision not to raise interest rates in September, the pound's value has declined against the US dollar. This is because the same investors selling UK Treasuries to drive up yields are also selling pounds to acquire US dollars.

 

The UK is not alone in experiencing these effects. The euro is weakening against the US dollar, and the Japanese yen is approaching its lows from around the same time last year. In each case, the reason remains consistent: the strength of the US economy in comparison to other economies is attracting more investors. Additionally, both the Eurozone and Japan have policy rates lower than those of the US, with their central banks indicating no intention to raise rates further.

 

Unfortunately, these developments, namely higher treasury yields and a depreciating pound, spell challenges for the UK economy. The increased yields mean higher borrowing costs for the government and individuals, including mortgage and business loan payments. The weaker pound makes imports more expensive, further contributing to inflationary pressures. With the economy experiencing sluggish growth, these factors collectively dampen the prospects for the UK.