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Gilts' curious stability

The Russian war has not raised gilt yields despite the prospect of higher inflation. There are good reasons for this
Gilts' curious stability

Don’t they know there’s a war on? We might ask this of the gilt market, because nominal gilt yields – at 1.3 and 1.5 per cent for five and 10-year maturities – are actually slightly lower than they were a month ago.

This seems odd because in raising many commodity prices the war will raise inflation, and inflation is supposed to be bad for conventional gilts simply because future coupon and redemption payments will be worth less in real terms.

In truth, though, there’s a simple reason why nominal yields haven’t risen. One is that the war has increased uncertainty, and increased uncertainty usually sees a flight to quality – to assets that are safer than equities, such as gilts.

The other is that higher commodity prices are a supply shock. Not only do they raise inflation but they also increase the costs of doing business and cut households’ real incomes, thereby reducing economic activity. And there is one asset that is wonderful protection against supply shocks – index-linked gilts. They protect us from the combination of higher inflation and weaker output.

That word “combination” is important. Index-linked gilts aren’t always protection from inflation alone. In fact, since 1990 there has been a positive correlation between 10-year index-linked yields and consumer price index (CPI) inflation, meaning that yields tend to rise (and prices fall) as inflation rises. This is because if inflation is caused by stronger economic activity – as it often was before this year – safe assets do badly as investors switch into equities. It is only when inflation is accompanied by fears for economic activity that index-linked gilts do well.

Which is just what has happened recently. Five-year index-linked yields have fallen by 0.6 percentage points, to minus 3.8 per cent, since the end of January. Yes, the market is now pricing in higher inflation than it was a few weeks ago, but it is doing so through lower index-linked yields rather than through higher conventional yields. To put this another way, the harm to conventional gilts of higher inflation has been offset by the benefits of a flight to quality.

In one sense, this is good news. It means the government can still borrow cheaply: for every £100 it borrows over 10 years it will have to repay only £73 in real terms. That means it has room to cut taxes or raise benefits in next week’s spring statement to mitigate the squeeze on real incomes; the obstacle to doing so is ideology, not economics.

Of course, we don’t know whether bond yields will stay low: much depends on the course of the war. An early end to it, though, might well see both nominal and index-linked yields rise. This would be partly because reduced uncertainty would reverse the flight to quality, but also because that same lessened uncertainty would stimulate economic activity and make central banks more comfortable about raising interest rates; bond yields, remember, should be equal to the expected path of short-term interest rates over their maturity.

In such a scenario, however, it’s likely that commodity prices would slip back as sanctions against Russia are at least partly eased, which would mean that the inflation threat would recede. And this gives us a nice paradox – that the biggest danger to conventional gilts comes not from inflation but from its opposite, from the possibility that the inflation threat will recede.