This is an audio transcript of the Unhedged podcast episode: ‘The rout in UK and European bonds’
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Katie Martin
The war in and around Iran has still got the global economy on edge. Now investors are obviously not the most important people in all this, but they are having a very tricky time of it. And by investors, I mean everyone from punters like you and me putting a bit of money aside in stocks or cash for a rainy day to the professionals who are managing billions in massive pension schemes.
And that’s because what we’re looking at here is either a modestly bad situation or a huge economic disaster. Nearly a month into the war, we still don’t know which one it is. So stocks and bonds and commodities and everything else are getting beaten up by every passing headline, but one corner of the markets has been hit especially hard, and that’s UK and European government bonds.
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That’s mostly hedge funds that have taken the immediate hit there. And I don’t know about you, but my tiny violin is at the repair shop. But longer term, this matters for everyone. Today on the show, we’ll tell you why the hedge fund struggle is your struggle too.
This is Unhedged, the markets and finance podcast from the Financial Times and Pushkin. I’m Katie Martin, a markets columnist here at FT HQ in bright and sunny London. Still got an annoying cold, but I’m being a hero and spreading my germs around with, in the studio, Mr Ian Smith — markets reporter extraordinaire, really quite knackered after a few wild weeks on the coal face of finance, Ian, it’s pretty relentless, isn’t it?
Ian Smith
It has been, but we love it. And thank you for sharing your germs with me today.
Katie Martin
That’s all right. Anytime. (Laughter) So UK and European government bonds. There was a, I don’t know if you saw it. There was a note out from David Zervos, who’s an analyst at Jefferies who was saying, oh, these rates traders in Europe, they’re so cranky.
But it’s just a little, irrelevant part of the markets. It doesn’t really matter.
Ian Smith
It feels relevant to us.
Katie Martin
It feels quite relevant actually to us because like, OK, it’s a little bit of a kind of specialist’s market, but it has been absolutely annihilated by what’s going on here. Give us a scale of how big the moves are.
Ian Smith
Yeah. What you’ve seen in bond markets is this move to price in a big inflation shock from the Middle East war. So you’ve seen short-term expectations for inflation surge with oil and gas prices, and it’s particularly hit countries that are more dependent on imported energy. And the UK is one of them, particularly gas. So you’ve seen European government bond markets hit especially hard even more than the US by that sharp rise in inflation expectations.
And really what’s driving that is the rise in inflation now being anticipated is leading people to jettison bets they have made on central banks cutting interest rates. So the Bank of England, before the war started, had been expected to make a couple of quarter of a percentage point cuts to its benchmark rate by the end of the year. That’s shifted now to two or three hikes anticipated by the market, which is an amazing move in a short period of time. For the ECB, it was a small . . .
Katie Martin
That’s European Central Bank.
Ian Smith
Yeah, the European Central Bank. A small chance of a cut running into the conflict. Now two or three hikes that are expected to contain inflation. And even the Fed, where two or three cuts had been expected before the conflict, now a hike is seen as more likely than a cut from here.
So there’s a substantial change in interest rate expectations, and that particularly hits short-term bonds, which track those interest rate expectations. So you’ve seen this brutal sell-off particularly in gilts, where two-year gilt yields, which move inversely to prices, have risen one percentage point, almost one percentage point, so around 4.4 per cent since the conflict.
Katie Martin
So short-term UK government bonds really got it in the neck. And I was talking to Rob about this the other day, but it’s like it’s quite hard to get your head around if you are in this market, if you’re in UK government bonds, if you’re in gilts. The stuff that we’ve seen over the past week or so is just absolutely off the charts.
Like it’s . . . The closest parallel I can think of is that famous time at the end of 2022 when the UK government bond market got just blown up by Liz Truss. Like some of the moves we’ve seen have been on a kind of . . . they’ve been quite reminiscent of that. So there was a massive move, like you say, on two-year UK government bonds on the day when the Bank of England had a decision last week. So prices went down really hard, which meant that yields went up about a third of a percentage point.
I know that doesn’t sound like a lot to normal people. That is a lot. The next day they went up by another fifth of a percentage point. That is a lot. And then we walked into the office on Monday, when it looked like the war was gonna get worse rather than better, right, because Trump was talking about, you know, an ultimatum and he hadn’t seemed to back down at this point. And gilts were getting fried. Like I was, you know, getting texts from people in the market saying this is grim. So I guess I’m wondering. Why is it that gilts got it in the neck so hard?
Ian Smith
That’s in part because of our energy mix. We’re very dependent on gas so we are particularly susceptible among big economies to a rise in kind of gas and oil prices, as opposed to the US for example, which has established itself as a big energy producer.
Partly it’s because of what I mentioned around interest rates where there had been those cuts expected. So, you know, the market had been anticipating more cuts than the Bank of England, whereas the ECB had been considered largely done with its cutting cycle, and partly because the UK has had sticky inflation. So running into the conflict, the UK inflation was running above 3 per cent, whereas for the Euro area it was down back down to two.
So we kind of higher inflation running in, more susceptible to a rise in that inflation and all of these bets that people have made on, you know, interest rates going. And it went the other way. It’s like a brutal mix, right? And exacerbated by some hedge funds that had taken positions like looking for short-term rates in the UK to move yields to move lower.
And in fact, when they went much higher, you saw, and that’s where the pain you’re talking about was coming from. You saw people getting squeezed out of trades, which then exacerbated the move higher in yields.
Katie Martin
Yeah, So as you say, we’ve got like a particularly tricky energy problem. We’ve got particularly sticky inflation. We also have that hangover from 2022. I know it seems silly to keep blaming Liz Truss for everything, but that time she blew up the bond market left a really long shadow and has left a lot of investors particularly outside the UK just a little bit nervous about dipping a toe in. You know, that sort of stuff, it doesn’t just fade quickly.
But also, one really important thing that I think is the thing that you mentioned about hedge funds. So investors come in different shapes and sizes, right? Some of them manage massive pensions. Some of them manage kind of mainstream funds that you can just get on to your phone and buy.
But hedge funds are kind of special, right? They operate pretty much without constraint. They can do what they want when they want and play in pretty much whatever market they want. And the whole idea is that they really swing big. They go for like punchy bets and they bet on them pretty much without constraint or do whatever they like with them.
That means that sometimes they make huge gains and the hedge fund managers themselves, you know, make very good money out of that. And sometimes they make huge losses. This is one of the latter times, right? So I guess that does leave you wondering. Why are hedge funds such a big part of this market and is that healthy? That is a reasonable question to ask, isn’t it?
Ian Smith
It is a reasonable question to ask. Sometimes hedge funds can be viewed as a bit of a bogeyman when there’s market volatility or let’s look for someone to blame. And like, there are good reasons why UK government bonds, we’ve laid out why they sold off so much.
But it is a really important question to ask. And increasingly so. We’ve seen traditional buyers of government bonds in the UK, pension funds, kind of pulling back from the market as those pension schemes, the old so-called defined benefit pension schemes, mature. Hedge funds have become a more important part of the market and it’s something that the Bank of England talks about in its financial stability report. You know, they do a lot of leverage investment in this market, and can they be exacerbating moves?
They also are, you know, a reliable buyer of these bonds. You know, we do need people to buy £250bn worth of UK tech a year at least. So, you know, you need buyers. But there are definitely some trades that in this volatility, we understand that did kind of blow up, such as ones on short-term government debt outperforming long-term government debt. So that’s, you know, what you call a steepener trade because the government yield curve would steepen.
So the sharp rise in short-term rates that we talked about did the opposite: government yield curves flattened, and that was a pain trade for hedge funds. Some had actively bet through options against there being any hikes priced. So those bets also got squeezed by that shift in interest rate expectations. And once the positions become so lossmaking they get stopped out, exiting them can kind of exacerbate the declines in government bond prices and other, you know, related derivatives that you’ve seen.
Katie Martin
Yeah. So it was a really bad few days in the office for some of these guys. We’ve got a bunch of stories out from our colleague Costas on what some of the losses look like there. But yet, as you say, it’s very easy to kind of look over at hedge funds, you know, in their fancy cars driving around Mayfair and say well, it’s all their fault.
Ian Smith
Did you call them the gilet brigade?
Katie Martin
I did call them the gilet brigade and I’m sticking with it. But it’s a bit lazy actually, just to blame them for all of this stuff. Because unlike other types of investors, it is true. They are very what you call price sensitive. So when stuff goes wrong, they get out. They get in, they get out, they shake it all about. Whereas if you’re a big pension fund, most likely you buy the bond and then you sit on that bond, tick-tock, tick-tock for like a few decades until it matures and then you buy another bond, right?
So they don’t kind of get in and out at anything like the same pace. But what I gather is like the organisations that issue debt on behalf of the UK, yes they can see that hedge funds jump in and out, but they do see that they’re there when the government issues debt, they buy it. And when you have dips in price in UK government bonds — so the yields go up and borrowing costs go up for all of us — they’re buyers. So I would just caution against, you know, anyone who thinks it’s all the hedge funds’ fault, let’s get out our pitchforks. You’re doing it wrong. Yeah.
Ian Smith
And also, it’s just quite ironically funny that some of them have been hurt for being too positive on gilts versus other markets. (Laughter) If the usual bogeyman is oh, they’re driving up our borrowing costs, it’s like, well, in this case, some of them were betting that gilt yields would fall more than other government bond yields and outperformance in bond terms, and that went wrong. So, you know, don’t be too positive. Not on the UK, but on UK government bonds.
And where it matters to the rest of us especially is that it’s not just short-term government bond yields that have risen. Longer-term government borrowing costs, which is what matters more to our kind of debt financing — and we pay more than £100bn a year servicing our debt in the UK — have also risen.
In Germany, the 10-year bond went above 3 per cent to its highest in more than a decade. UK, we saw the 10-year go above 5 per cent — highest since 2008. So this is a real-time kind of tightening of financial conditions for businesses and consumers, you know, through the transmission through mortgages. But also for governments who are having to borrow a lot at the moment, this creates fiscal pressure, which would be made worse if they do things to insulate their consumers against the energy shock. So you’ve seen weakness in the longer end of the government bond market too.
Katie Martin
And normally you could say oh, well, you know, the hedge funds have, you know, blown up in the short end, they’ve blown up on the short-term debt, but that doesn’t really bother the rest of the country.
But governments have shifted, not just in the UK but in Japan and in the US and in a lot of different places, into issuing more short-term debt because of like demographics and a few reasons that are probably too technical to go into. But, so that means that short-term borrowing costs actually matter to all of us.
But I kind of wanna go back to almost the beginning of this conversation, right, which is, what is this conflict doing to inflation expectations? Because that’s the problem, isn’t it? So it is not just oil and gas that have gone up in price. Stuff like fertiliser has gone up a lot in price. And if you don’t have fertiliser, you don’t have food, or at least you don’t have so much food.
Guess what happens if you don’t have so much food? Prices of food go up. So there is a kind of worry that we could be entering a whole new inflationary phase that nobody had predicted. ’Cause it really looked like we were coming out of that whole nightmare after Covid and Russia’s invasion of Ukraine and yada yada.
Now it’s back. And also, it’s not just inflation, but you were writing about this the other day. It is that scariest of things. Stagflation is the risk of the thing that we’re looking at, right? So you have economic stagnation, you don’t have economic growth, but you do have inflation. Not good. Nobody likes this.
Ian Smith
Not a party that anyone wants to go to.
Katie Martin
No.
Ian Smith
So the debate is, are we heading there? Obviously if there is a truce or something more, you know, negotiated solution that sees oil and gas prices fall, short-term inflation expectations will come back some, but there’s already some damage done to, you know, inflation expectation. Also, just price of goods that are moving around already. So some of that damage is done and some of the damage to growth is being done. So even as the conflict stands — you know, speaking to people for that Big Read — there’s definitely a more massive . . .
Katie Martin
Yeah. You wrote a Big Read about this for the paper the other day, yeah.
Ian Smith
I spoke to people like Kenneth Rogoff, formerly of the IMF, who thinks, you know, this is the biggest stagflationary shock in five decades that could be unfurling here. So just . . .
Katie Martin
Yeah. Fun chat, that sounds like, yeah. (Laughter)
Ian Smith
It was a sunny quote to finish off that piece. But yeah, the stakes are real here. I think as you’ve written about, it’s quite hard for the market ’cause you’re trading a couple of scenarios. One where things go back to normal. And everyone using scenarios to hide behind shows that it’s quite hard to construct trades.
But we do know that some of the economic and, you know, the growth and inflation damage from this is already happening. And that’s what we’re seeing the bond market respond to, especially now. If people started to really worry about the growth impact and think it was so bad that central banks have to cut interest rates come what may — and there’s big debate about whether they should look through the inflation — then you could see government bonds start to perform well.
So it’s kind of really gonna be interesting to watch the market to see is there a tipping point where the market gets more worried about the growth impact than the inflation impact?
Katie Martin
Yeah. Right now it’s the “flation” bit, not the stag bit that’s doing the heavy lifting.
I wanna take this back to why normal people need to care about this, and one reason for that is because, like we were saying, in the UK for example bond prices have fallen, bond yields have pushed up. That means that borrowing costs have jacked up for all of us. One way that ordinary people might feel this is that a lot of mortgage products are just disappearing from the online shelves, so there might have been some deal that you had your eye on to buy your first home or to refinance your mortgage, which it’s worth bearing in mind we do that in the UK a lot. We get a new mortgage every two to five years. The Americans, I don’t get it. You bake in a rate for like 30 years. Blows my mind.
Ian Smith
Sounds good to me right now. I’ve gotta refinance later this year. (Laughter)
Katie Martin
But, so I was asking our colleague James Pickford, who writes about this for us, and he was saying that lenders have withdrawn more than 1,500 of their products since the beginning of March, leaving just 6,000 behind. So that’s a massive reduction in the number of mortgage products that are out there for people to buy homes. So, you know, you might think to yourself, oh, you know, who cares about two-year gilt yields? This is like nerdy stuff only boring people like Katie and Ian care about this sort of thing. But no, you need to care about it too, boys and girls.
Ian Smith
Sadly you do, yeah. And it’s no coincidence, right? The last time mortgage deals getting pulled at this rate was 2022, which was the last time sovereign bond markets at the short end were having such bad performance. Yeah. There are like big parallels and yeah, everyone has to care about it the rise in interest rate swaps to the two- and five-year, it feeds into the pricing of mortgages. So you’ve just tracked exactly what we’ve seen with government bond yields and it’s, yeah, it’s quite scary for people that are thinking, I’m going to have to remortgage.
And then it’s a question of that very unclear picture: like, what do you do? How long do you fix for? It’s incredibly difficult . . .
Katie Martin
Yeah. Do I fix my mortgage for five years? Do I fix it for two? Do I think things are gonna get a lot better or a lot worse? Here’s the thing: if you are trying to get yourself a mortgage and you’re trying to decide what to do with it and you think, well, I don’t know, I’m not an expert. The experts don’t know either. I need you to know this. Nobody knows what’s going on.
Ian Smith
That’s what’s terrifying about a mortgage is so you’re having to take one of the most difficult decisions about, you know, how you think central banks will react to, you know, a really uncertain, you know, inflation growth picture. It’s always uncertain, but the moment, you know, the idea that everyone has to do that is quite scary.
Katie Martin
Yeah. But never think to yourself that you are the only one who doesn’t know, because literally nobody knows.
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Look, it keeps us in a job, Ian, gives us something to talk and write about. So thanks for sharing your brain on this. W’re gonna be back in just one second with Long/Short.
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Okie doke. It is time for Long/Short, that part of the show where we go long a thing we love or short a thing we hate. Ian Smith, what are you saying?
Ian Smith
I’m gonna go long a new Harry Potter TV series.
Katie Martin
Oh, are you?
Ian Smith
Having just seen the trailer and watched it with my daughter this morning.
Katie Martin
How old is she?
Ian Smith
Seven.
Katie Martin
Oh, this is like gonna be her jam, right?
Ian Smith
So she’s right in the middle of reading these books and yeah, based on her reaction to the trailer . . . And I know there’s been lots of, you know, negativity around it and people not maybe liking some of the development of it, but I just think it looks great. She thinks it looks great. So I’m gonna buy the dip in Harry Potter TV series’ reputation.
Katie Martin
(Laughter) Yeah. This sounds like it’s gonna be very much up your alleyway. I am short boy kibble. So . . .
Ian Smith
Is that something to do with dogs again?
Katie Martin
Well, it’s sort of like dog food, but for boys.
Ian Smith
Right.
Katie Martin
The Guardian writes to inform us that health-conscious Gen Z men have started using the term boy kibble to describe a quick and easy meal — ground beef, rice and sometimes a vegetable or fat. It’s popular with gym bros, and apparently it can help you maximise your workout gains. Gym bros, I need you to know you have not invented this. This is just food, just rice and meat is just . . . That’s food.
Ian Smith
Doesn’t sound like your “looksmaxxing”.
Katie Martin
No, no. But like, you can’t just like put like a tomato sauce on some pasta and say you’re like “pastamaxxing” or like you’ve invented something.
Ian Smith
And get in the pain cage, (laughter) as I call my workout apparatus.
Katie Martin
I’m delighted to hear that these young men are cooking themselves nice, nutritious meals, but like, you know, knock it off. You have not invented this. This is just food.
Ian Smith
I think they’re gonna be devastated by this put-down from you, Katie.
Katie Martin
Right? I’m sure they’re big listeners to the show. This is right up their street.
Ian Smith
Big time. Yeah.
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Katie Martin
Yeah. Well, if you have complaints, email them to either [email protected], or maybe [email protected] if you fancy it. In the meantime, we will be back in your ears on Tuesday, so listen up then.
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Unhedged is produced by Jake Harper and edited by Bryant Urstadt. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhecz. Cheryl Brumley is the FT’s global head of audio. Special thanks to Laura Clarke, Alastair Mackie, Gretta Cohn and Natalie Sadler.
FT premium subscribers can get the Unhedged newsletter for free, and a 30-day free trial is available to everyone else. Just go to ft.com/unhedgedoffer.
I’m Katie Martin. Thanks for listening.
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