The rout in UK and European bonds

Katie Martin (0:06)

Pushkin. 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. Now, it'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 funds 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 (1:36)

It has been, but we love it. Thank you for sharing your germs with me today.

Katie Martin (1:39)

That's all right, anytime.

So UK and European government bonds, I don't know if you saw it, there was a note out from David Zervos as an analyst at Jeffreys, who was saying, 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 (1:59)

It feels relevant to us.

Katie Martin (2:00)

It feels quite relevant actually to us, because like, okay, it's a little bit of a kind of specialist 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 (2:14)

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 (3:07)

So that's the European Central Bank.

Ian Smith (3:09)

Yeah, the European Central Bank, a small chance of a cut running into the conflict. Now two or three hikes 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 it'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, around 4.4% since the conflict.

Katie Martin (3:44)

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 quite hard to get your head around if you're 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 the closest parallel I can think of is that famous time at the end of 2022 when the UK government bond market got 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 going to get worse rather than better. Right, because Trump was talking about an ultimatum and he hadn't seemed to back down at this point. And gilts were getting fried. Like I was 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?