What’s bothering bonds?

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0:32Rob Armstrong: Pushkin. Stock markets are so hot right now. People keep telling me with a straight face that the biggest risk in stocks today is that we're not taking enough risk in stocks. Let's see how that one ages, shall we? Anyway, meanwhile, bonds not happy. Like they're really not happy. Bond prices are down, which means borrowing costs are cranking higher all over the world. Meanwhile, the UK has done what it does best and manufactured a political crisis out of thin air. So UK government bonds, or gilts, are really feeling the heat. Today on the show, what's bothering bonds, why do normies care, and how can the UK avoid making a bad situation worse?

1:19Rob Armstrong: This is Unhedged, the markets and finance podcast from the Financial Times. I'm Pushkin. I'm Katie Martin, a markets columnist down in the dungeon at FT Towers in London, which is inexplicably freezing cold. I'm joined, as usual, by the big man in New York City, Mr. Rob Armstrong. Rob, do you have your special chair again? Yes, they've got me locked in place again. Good.

1:43Katie Martin: This is what it's come to.

1:46Rob Armstrong: I'm joined right here in the London studio by our newbie on the Unhedged newsletter, Darren McFadden. You've been at the FT for like a month. You came from the Bank of England. You came from a proper job. How are you liking our funny ways? Is it a very different place to be? I mean, it's basically anarchic. I think my imagination of how a newsroom function would have been an editor stood atop a command structure asking for this by five o 'clock, this for tomorrow. And instead, it all just comes together with everyone just doing their work.

2:21Katie Martin: This is what I tell this to every time someone joins the FT. They say, you know, what do I need to know? And I tell them, there are no rules and no one is in charge. And they think I'm joking. And then they work here for a couple of months. They come back and they're like, oh, you weren't kidding. Yeah.

2:39Rob Armstrong: Let's just hope the editor doesn't hear this.

2:41Katie Martin: Yeah. Good heavens.

2:42Rob Armstrong: It's quite a grand building, Bank of England, isn't it? It's like part of old London. It's one of the bits of old London that didn't get bombed back in the day. It must have been kind of quite a special place to work. Yeah, weirdly. I mean, from the outside, it looks like a beautiful building. But there are all sorts of downsides to working in a, you know, 100-year-old building now that's single glazed windows. It's very drafty. You have to walk 10 minutes to get to any meeting room. Yeah. So it is a relief to work in a more modern office building. We're dead glam here. So look, we're the FT. We're a London institution.

3:16Rob Armstrong: So let's start with the UK. The UK has got itself into a bit of a pickle here, right? So the UK government bonds market, which everyone calls the gilts market over here, we borrow a lot relative to the size of our economy, but we're really tiny in the global scheme of things. We're much smaller than treasuries. And so that does mean that we sometimes muck it up and gilts get really volatile. In a nutshell, Dara, what is going on at the moment? Well, to start with, yeah, like you said, Katie, the size of the UK gilt market is a lot smaller than the treasury market. So there's a lot more of a risk that investors in gilts would lose interest in being invested in gilts.

4:03At the moment, the UK is in this very tricky situation of being at the center of both global dynamics that are pushing up yields internationally, and a sort of political crisis taking place in the UK now, which is adding to the yield on the longer dated gilts. Can I provide some context here as the crass American?

4:23Katie Martin: I am looking at a screen here that has all the European bond yields on them, the 10-year bond yields.

4:33Rob Armstrong: I know where this is going.

4:34Katie Martin: And nobody is close to the United Kingdom at 5.01 % as of this morning. Italy, 3.78. Italy, all respect to Italy, but fiscal responsibility is not their national motto. And I just don't understand why the United Kingdom is so out of whack with the rest of the continent.

5:04Rob Armstrong: Well, are you aware, Rob, that we're not in the Eurozone?

5:07Katie Martin: I said the continent, and I think the islands that make up the United Kingdom as part of the European continent. The same way Long Island is part of the North American continent.

5:21Rob Armstrong: The same way Canada is part of the European continent.

5:23Katie Martin: This is on Hedge, the geography podcast.

5:26Rob Armstrong: Maps on the radio. So look, part of it is we're not in the same currency. Like, you know, Italy uses the euro, Greece uses the euro, France uses the euro, Germany, yada yada. We use sterling. So it's like it's not quite comparing apples with apples. And we don't have the same central bank. So we don't have the same base rate between the two. So like European benchmark interest rates are like 2 percent. Like, yeah. And, you know, we're we're what are we at, Dara?

5:54Katie Martin: We are at 4.25. Dara actually set that interest rate before he quit that job to join us here at the Unedged. That was his last act. Thankfully, I never had to work on monetary policy.

6:08Rob Armstrong: It's too hard. It's too hard. So look, we're at completely different starting points, but nonetheless, cannot sugarcoat it. UK borrowing costs are higher. We've got more of an inflation problem than a lot of other developed market economies. We've got this piddly little bond market that's just not on the same scale as certainly as the US. And also, if you're in Europe, if you're in the Eurozone, then you enjoy like a sort of safety net from like an alphabet soup of rescue programs that are out there at the European Central Bank that it can kick in for pretty much whatever reason it wants, pretty much whenever it wants.

6:47Rob Armstrong: If one national bond market goes haywire in Europe, they can just hose that down.

6:52Katie Martin: So there's a safety in numbers thing there, basically. Maybe that's a bit of a simplification.

6:57Rob Armstrong: They've got backup. They've got some issues, but they've got backup and it's just different. The European Central Bank is willing to kind of step in in the event that the spreads between all of the European bonds start diverging too much. That's critical to maintaining a single currency area. We have a central bank that is willing to backstop the market when there's a sort of systemic risk to financial stability, as happened in September 2022. but that was to do with the business models and the balance sheets of particular sectors in the economy like pension funds and insurance companies.

7:35Katie Martin: Have we hired someone who knows what he's talking about, Katie? I thought we had a rule about this. I'd say one other thing to bring into this, or a couple of other things. One is that the UK does have a very high level of debt as a percentage of GDP. And so, yes, it's a piddly bond market, but it is large by European standards.

7:55Rob Armstrong: You're right. We've got a lot of outstanding debt. And here's a little thing that the UK Chancellor Rachel Reeves is always pointing out, which is one pound in every 10 pounds the public sector spends now goes on debt interest, which is four times what we spend on nurses. so like there's this idea like politicians who are like you know on the outside of the tent pissing in are always like oh we should ignore the bond market the bond market is terrible why are we pandering to all these awful speculators we should just do what we want and the bond market is going to have to suck it up and it's like no no sure that's fine that's a political choice but if you do that you can't afford any nurses but it's so you know i think there's this idea that the bond market is completely separate from real life and from politics and that you can afford to like just sort of do what you want.

8:46Rob Armstrong: That's the thing about the bond market.

8:47Katie Martin: It's made of money. You know, this is a very important fact about it. And that demands respect. And also you should care what proportion of your debt is held by overseas investors. So the UK over the last couple of decades, or even less than that over the last decade, it's seen a growing share of its public debt held by overseas investors. These are people who have choices which public debt they want to invest in. And they don't need to stay invested in gilts. You know, if gilts don't provide a good return on investment, and if they don't think that the government has a credible strategy for getting, you know, keeping inflation close to target and getting fiscal expenses down, then they can shift into treasuries or bonds or you know some emerging market asset class i noticed the australian 10 year is also paying five percent so you can flip over to australia

9:41Rob Armstrong: and get the same yield and also there's the currency thing right so if you think sterling is going to weaken a lot then why would you want to hold the bond so that there's a lot going on here but so there is a whole global situation which we'll come up come on to in a minute but But in the meantime, so while we have got borrowing costs pulling higher across the whole of the world and the UK is quite sensitive to that anyway, in the middle of all that, we've had some local elections in the UK that have been like a big punch in the nose for Prime Minister Keir Starmer. All of a sudden, other people in and around the Labour government want to get in on the act, want to like, you know, oust him out of his job.

10:20Rob Armstrong: It also looks like other parties that are much more to the right or to the left are kind of more credible. They've got a more credible claim on government really in the next general election. So again, like just as Darrow was saying, if you give people a reason not to buy gilts, then maybe they just like won't buy gilts. And there's an element of that that is making the situation for the UK market a little bit worse.

10:48Katie Martin: Shall we go to the world now? Shall we broaden the lens to the world?

10:51Rob Armstrong: Well, just really quickly, before we go to the world. So I wrote at the weekend about, look, bond markets are important and bond markets are a friend. And if politicians had any sense in the UK, they would stop antagonizing the bond markets and just accept some of the constraints and trade-offs that we all live with. I got feedback on that from people on the internet. Some of it constructive, some of it not. But some of them were like genuine questions that I think are not stupid. One of them was, well, why can't the Bank of England just buy all the bonds? Dara, why can't the Bank of England just buy all the bonds?

11:25Well, the Bank of England has bought a lot of the bonds over the last 18 years. It is now selling a lot of them back into the market. That's part of the reason that the yield has been pushed up. But one reason you don't want the central bank to be an outright holder of a large proportion of the public debt is that that can contribute to inflation. You know, if you have the central bank monetizing the debt, then there's no constraint on the government's ability to issue or to make new spending commitments. So it is in principle, it's a good idea to have a central bank with a relatively smaller footprint in financial markets and allow the price discovery to take place in the market.

12:08Rob Armstrong: Yeah, because if inflation gets out of hand, bonds really hate that.

12:11Katie Martin: I mean, it's printing money, right? issuing bonds and having the central bank buy them is printing money.

12:18Rob Armstrong: You're not wrong. And it's fine in a crisis, right? You know, to get you out of a hole, everyone says, oh, you know, we hate printing money. Oh, oh, there's a massive recession, you say. Sure, I'm going to print that money. You know, money printer go brr. But generally speaking, it's just not a smart thing to do. So that's why the Bank of England doesn't just buy it all. Another question that someone was asking me, and I can't tell whether they were being entirely serious, but to Rob's point, why doesn't the UK just issue all its debt in euros if the yield is cheaper there? Well, we've heard this recently.

12:54There was a column in the FT, actually, from somebody suggesting this. But again, it kind of comes down to the point about what view you want to take on the value of sterling and whether that's going to stay constant or depreciate. And so it would be a bit of a punt for the government to start doing

13:12Katie Martin: that. And it makes local... Oh, I'm sorry, I keep interrupting even worse than usual. Go ahead, Katie, please.

13:18Rob Armstrong: And like, if we Brits issued everything in euros, and then the value of the euro went up a lot, for whatever reason that we can't control, then we're screwed. And we're suddenly paying back debts that are much, much more expensive. So various countries in Central and Eastern Europe, Poland and Hungary. They had lots of like back in the day, they had loads of debts like mortgages that were in Swiss francs. Anyway, Swiss franc blasted higher. A lot of people got absolutely annihilated. So if you're not issuing in your own currency, you're introducing risks that kind of don't have to be there. This is what happened during the Asian financial crisis where you had all of these countries in Southeast Asia who had issued debt in US dollars.

13:59And then when the money flowed out, they didn't have the dollars to make those interest payments.

14:03Rob Armstrong: Yeah, yeah. So bad things can happen. The third sensible question that people have been asking me about why the UK market is in such a hole is, look, if bond investors like it so much, if governments are boring and sensible, then why is the US government bond market not bleeding out at the moment? Rob, I will throw that to you.

14:24Katie Martin: I think it's because of the size, liquidity, and structure of the market rather than the quality of the asset. So it's a universally accepted, highly liquid, large, easy-to-access market in a currency that everybody understands and wants. So in global bond markets, it pays to be the biggest. and the US is the biggest.

14:56Rob Armstrong: Yeah, the US has this exorbitant privilege of being the world's dominant reserve currency, dominant reserve asset. It can get away with stuff basically that no one else can. So if the Brits try and be all American, then we get absolutely flayed for it. As we were saying right at the top, like the real problem with what's going on with Gilts at the moment is that everything is really under the cosh. So even Japanese 30-year bond yields are getting close to 4%. The US just earlier this week had to issue, was it 10-year debt, or 30-year debt?

15:29Katie Martin: 30-year debt. Over a 5 % yield. For the first time in decades, it's a 5 % yielding piece of paper from the United States government. This is a big moment.

15:38Rob Armstrong: Robert Armstrong, tell us why this is happening.

15:41Katie Martin: Well, I think it's global to a certain degree. I think there are global concerns about inflation and probably even more than that. There are global concerns about fiscal responsibility on the part of the, you know, the developed world's governments. Right. So we want more. We want more yield because we want more inflation insurance. But more importantly than that, the developed world is more and more indebted. So it's worse and worse a credit. And so you need a little bit more. Yeah.

16:19Rob Armstrong: So things that bonds hate include inflation and they hate having loads and loads of bonds. You know, it's just a supply and demand thing, right? If you have loads of bonds flooding the market, then the value of those things goes down. What we're looking at partly as a result of what's going on in Iran is inflation and loads and loads of new bonds to help governments pay for defense and a green energy transition and all of that sort of stuff. So it's just a combination of stuff that bond investors really hate. And like, so just earlier this week, there was some nasty inflation data out of the States, right, Rob, that you had PPI inflation.

16:57Rob Armstrong: It's like wholesale inflation, sometimes called factory gate inflation.

17:02Katie Martin: What producers are paying rather than what consumers are paying. It's like, you know, CPI for companies, basically. And it was very high. All the inflation numbers are a bit weird now because the energy crisis makes all the numbers a little jumpy for reasons and companies are changing prices quickly and so forth. I wouldn't say that either the recent CPI data or the recent PPI data radically changed the picture of inflation in America. It was more like confirming. Inflation is not dead. and everybody hopes the next report will be the one that shows we're going back to normal two percent is in sight and each report comes out and it's just like we're in a three percent world

17:51Rob Armstrong: people and so us ppi inflation uh that came out earlier this week was up six percent year on year

17:59Katie Martin: and there was some one timers in there whatever sure sure the point is three percent world not getting better. 3 % and not improving. It's not the 1970s. Nobody's paying for groceries with a wheelbarrow full of money, but we're not supposed to be at 3%, we're supposed to be at 2%. And over time, the difference between 3 % and 2 % is large, compounds into a big amount. So it's important.

18:29Rob Armstrong: So what do we think? Let's take it back to the UK. What do we think happens next? like Dara what are your spidey senses do you think this is all going to get a lot worse before it gets better or do you think this is a bit of flim flam about nothing I think it could get worse before it gets better I think one of the risks here is that there could be a challenge to Sir Keir Starmer the Prime Minister and depending on who comes out tops in that contest for the leadership of the Labour Party there could be a swing or a lurch to the left that means slightly more spending, more social commitments. And it's just not clear that the bond market really wants to absorb all that additional borrowing.

19:12So there's a real question there around whether the bond market is going to kind of reimpose discipline on whoever comes into power if Keir Starmer leaves. And in fact, there was a column in the FT yesterday arguing that you could actually be long on on on guilts because the bond market generally uh has a way of imposing discipline and constraints on uh on governments that um get a bit too out of hand i think like a lot of sort of

19:39Rob Armstrong: you know brit investors who i speak to are like yeah you know this is a pretty bad situation people outside the uk are like oh god you brits will figure it out you always figure it out like i don't know i don't know how you're going to make this work but you're going to make it well You're not going to do another like Liz Truss thing end of 2022. You're not going to like throw a grenade at your national bond market because you saw that ended quite badly last time. So let's not do that again. But like basically my view, I think we're just adjusting to a new world of permanently higher debt levels and aging demographics.

20:13and we will find some way to accommodate this additional supply, whether that's central banks buying it or cutting social spending. Something has to happen.

20:26Katie Martin: Or deciding you're okay with the 3 % world or whatever the number is. That's the way you make debts lighter, is you tolerate a bit more inflation over time and the debts automatically lighten over time. Yeah, very few advanced economies have gotten back to their 2 % inflation targets since the energy spike in 2022. And so the question is whether they even have 2 % inflation targets anymore. Are they able to meet them over the medium term or not?

20:54Rob Armstrong: They're less of a target and more of a flaw now, I think we can all agree. We should have all taken advantage of zero interest rates, borrowed like mad, piled into green energy. Maybe we wouldn't be in the situation.

21:06Katie Martin: Somebody on this podcast has a two and three quarters mortgage for 30 years. I'm not saying who it is, but he's feeling pretty good about life.

21:18Rob Armstrong: You and your 30 year mortgage. Suckers. So the moral of the story is, yes, we have a problem here, but everyone just calm the heck down about the UK. Otherwise, I'll get very grumpy about it. OK, we're going to be back in just one second with Longshore.

21:47Katie Martin: Markets move fast. Get the insights you need in 10 minutes with Barclays Brief, a podcast from Barclays Investment Bank. Each week, our experts analyze market themes, helping you anticipate what's next. Listen to Barclays Brief wherever you get your podcasts.

22:03Rob Armstrong: already 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 i will go first i had a tough assignment this week i went to an event in paris i just want to go along there's a little shop in the garde du nord when you're about to get the train back to london that sells delicious little macarons and they are very very good It's about like 35 euros for a box of these things to take home, but they are fine and they always make up for me being away for a few days. Guys, what have you got? Rob, what are you saying?

22:39Katie Martin: I am short shampoo, which is, as every bald person knows, a frivolous product that the world does not need. Rob, you should be going long shampoo because of all of the hair treatments that are coming in these days. Good point. That's a good point, Dara. thinking like a traitor. I like that. I like that.

22:58Rob Armstrong: Dara, what are you saying? What's your inaugural long short? So it was reported this week that Limebike is going to IPO at some point soon. And there are blight on the streets of London, I would say, because they encourage a lot of people who are not regular cyclists to get on bicycles with an electric power assist and zigzag in all sorts of directions.

23:21Katie Martin: I don't understand why there haven't been more accidents. well there have been yeah yeah in emergency rooms here the doctors have have taken to calling a new kind of injury line bike leg which is when your your leg is broken from one of the bikes falling

23:36Rob Armstrong: on your leg before the lime prs get onto us i'm sure some people have a very nice time on line bikes i'm just saying i find them annoying right and the reason i'm short line bikes is that i don't believe they last very long i don't know what the shelf life of a line bike is because at least around East London where I live, it's not uncommon to see them at the bottom of the canal. So there's an IPO to watch. Those annoying little green bikes. Chaps, we're going to have to wrap up. Listeners, that's it for today. We are going to be back in your ears on Tuesday. So listen up then. Unhedged is produced by Jake Harper and edited by Brian Erstad.

24:16Rob Armstrong: Our executive producer is Jacob Goldstein. We had additional help from Topher Forehead. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Greta 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 slash unhedged offer. I'm Katie Martin. Thanks for listening.

24:54We'll be right back.