The rout in UK and European bonds

0:08Ian Smith: 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.

0:46Ian Smith: 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 fund struggle is your struggle too. This is Unhedged, the markets and finance podcast from the Financial Times. I'm Pushkin. I'm Katie Martin, a markets columnist here at FTHQ 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 coalface of finance.

1:34Ian Smith: Ian, it's pretty relentless, isn't it? It has been, but we love it. And thank you for sharing your germs with me today. That's right, any time. 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 Jeffries, 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. It feels relevant to us. It feels quite relevant, actually, to us because, like, OK, it's a little bit of a kind of specialist market, but it has been absolutely annihilated by what's going on here.

2:11Ian Smith: Give us a scale of how big the moves are. 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 had made on central banks cutting interest rates.

2:51So 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... So that's 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.

3:23So 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.

3:44Ian Smith: 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. 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.

4:25Ian Smith: 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, you know, an ultimatum and he hadn't seemed to back down at this point. And guilts 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 guilt's got it in the neck so hard?

5:06That'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 from 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%, whereas for the euro area, it was down back down to two.

5:47So 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 interest rates going and it went the other way. It's like a brutal mix, right? And exacerbated by some hedge funds that have taken positions 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. Yeah.

6:18Ian Smith: 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 onto 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.

7:12Ian Smith: 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? 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.

7:50And there are good reasons why UK government bonds that 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 leveraged investment in this market and can they be exacerbating moves yeah they also are you know a reliable buyer of these bonds you know we do need people to buy 250 billion pounds worth of UK debt 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.

8:42So that's 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 loss making, they get stopped out. Exiting them can kind of exacerbate the declines in government bond prices and other related derivatives that you've seen.

9:14Ian Smith: 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 yeah, 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. Did you call them the Gillet Brigade? I did call them the Gillet 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.

9:47Ian Smith: 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.

10:29Ian Smith: 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 and also yeah it's just quite ironically funny that some of them have been hurt for being too positive on guilts versus other markets if the 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 guilt yields would fall more than other um government bond yields and outperformance in bond terms and that went wrong so you know don't be too positive not in the uk but on UK government bonds.

11:00Yeah. Where it matters to the rest of us especially is that it's not just short-term government bond deals that have written. Longer-term government borrowing costs, which is what matters more to our kind of debt financing and we pay more than£100 billion a year servicing our debt in the UK, have also risen. In Germany, the 10-year bond went above 3 % to its highest in more than a decade. The UK, we saw the 10-year go above 5 % 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.

11:35But 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.

11:49Ian Smith: And normally you could say, oh, well, you know, the hedge funds have 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 to all of us but I kind of want to go back to almost the beginning of this conversation right which is what is this conflict doing to inflation expectations because that's that's the problem, isn't it?

12:26Ian Smith: So it's not just oil and gas that have gone up in price. Stuff like fertilizer has gone up a lot in price. And if you don't have fertilizer, 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 because 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.

12:58Ian Smith: 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. Not a party that anyone wants to go to. No. 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 full 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 um there's definitely a yeah You wrote a big read about this for the paper the other day.

13:46Yeah, I spoke to people like Kenneth Ogoff, formerly of the IMF, who thinks this is the biggest stagflationary shock in five decades that could be unfurling here.

13:55Ian Smith: Fun chat, that sounds... 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 because you're trading a couple of scenarios, one where things go back to normal, and everyone using scenarios to hide behind shows is that it's quite hard to construct trades. But we do know that some of the economic and 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.

14:37So it's kind of really going to 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?

14:44Ian Smith: Yeah, right now it's the flation bit, not the stag bit that's doing the heavy lifting. I want to 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 is 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 sounds good to me right now I'm gonna refinance later this year.

15:32Ian Smith: 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 guilt 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 sadly you do yeah and it's it's no coincidence right the last time mortgage deals getting pulled at this rate was 2022 it was just 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 carry care about it the the rise in interest rate swaps of the two and five year and 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?

16:36How long do you fix for? It's incredibly difficult. Yeah do I fix

16:39Ian Smith: my mortgage for five years? Do I fix it for two? Do I think things are going to 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. That's what's terrifying about a mortgage is that you're having to take one of the most difficult decisions about how you think central banks will react to a really uncertain inflation growth picture. It's always uncertain, but at the moment, the idea that everyone has to do that is quite scary.

17:12Ian Smith: Yeah, but never think to yourself you're the only one who doesn't know because literally nobody knows. Look, he keeps us in a job and gives us something to talk and write about. So thanks for sharing your brain on this. We're going to be back in just one second with Long Short.

17:34Ian Smith: 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? I'm going to go long a new Harry Potter TV series. Oh, are you? Having just seen the trailer and watched it with my daughter this morning. How old is she? Seven. This is going to be her jam, right? So she's right in the middle of reading these books. And based on her reaction to the trailer, and I know there's been lots of 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.

18:10So I'm going to buy the dip in the Harry Potter TV series reputation.

18:15Ian Smith: Yeah, this sounds like it's going to be very much up your alleyway. I am short boy kibble. Is that something to do with dogs again? Well, it's sort of like dog food, but for boys. 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 can help you maximize 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 doesn't sound like your looks maxing no no but like you can't just like put like a tomato sauce on some pasta and say you're like pasta maxing or like you've invented something and get in the pain cage as I call my workout apparatus I'm delighted to hear that these young men are cooking themselves nice nutritious meal but like you know knock it off You have not invented this.

19:23Ian Smith: This is just food. I think they're going to be devastated by this put down from you, Katie. Right? I'm sure they're big listeners to the show. This is right up their street. Big time. Yeah. Well, if you have complaints, email them to either robert.armstrong at ft.com or maybe unhedged at ft.com if you fancy it. In the meantime, we will be back in your ears on Tuesday. So listen up then. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Foreheads. Cheryl Brumley is the FT's Global Head of Audio. Special thanks to Laura Clark, Alastair Mackey, Greta Cohn and Natalie Sadler.

20:02Ian Smith: 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 slash unhedged offer. I'm Katie Martin. Thanks for listening.

20:29We'll be right back.