The Rise In Bond Yields And Brexit

by: John M. Mason

Summary

More information relating to the rise in bond yields in the United States and the accompanying increase in inflationary expectations to Brexit and what is now going on in Great Britain.

After a speech by Theresa May, British prime minister, set off a drop in the value of the pound, breaking the former relationship between gilt prices and the pound.

The culprit behind this break seems to be the rising expectation of inflation in Great Britain and this belief seems to be tied to events in the US and Germany.

Bond yields in the United States have just taken a big rise and the move seems to reflect a rise in inflationary expectations. But, the question is… where did the rise in inflationary expectations come from?

In my recent analysis of the situation, I observed that the recent timing of the increase in longer-term bond yields and inflationary expectations appeared to have begun just around the time that the yields on longer-term bonds in Great Britain took a significant jump upwards.

And, the timing of this move seemed to be associated with a speech given by British Prime Minister Theresa May at a meeting of the Conservative Party in late September. The speech had to do with the belief of Ms. May that Great Britain was facing a "hard" exit from the European Union and that she was focused more upon social issues than economic issues.

The market fallout from this talk was a collapse in the value of the British pound. In the last week of September, it took $1.30 to acquire a British pound. At the start of the first week of October, it cost around $1.27 to purchase a pound. And, within the last few days the price has been below $1.22.

Not as well noticed was the fact that the yield on longer-term government bonds began to raise quickly.

On September 28, the yield on the 10-year "gilt" closed at 0.68 percent. On October 3, the yield closed at 0.78 percent, and on October 10, the yield had topped 1.00 percent. On Monday, October 17, the yield was at 1.22 percent during the day, although it closed at 1.13 percent.

The peculiar thing about this market response was that it broke a relationship between movements in the pound and the movements in the yields on gilts. Previously, when the value of the pound declined, the yield on British gilts fell. So, we got a highly unusual market behavior.

This unusual behavior is now being reviewed in the press.

"Until this month, sterling was the asset that best reflected investors' attitude towards the UK's vote to leave the EU…."

"Now, however, that role is also being taken up by the debt markets, pushing down prices for UK government bonds and raising the country's cost of borrowing not seen since the June referendum."

"Amid rumors of a rift within the government between 'hard Brexit' proponents and those more concerned about the potential economic damage of the EU split, the pound has continued on its path of volatile weakening, while gilt prices have plunged."

"The fear in the bond market is attributed to a dawning realization that the scale of the pound's 18 percent post-Brexit slide has not only slashed returns for overseas investors, but already delivered a bigger-than-expected inflationary impetus… Annual consumer price inflation last month jumped to a two-year high…"

Further in the article, Adam Cole, G10 FX strategist at RBC Capital Markets is cited as arguing that the market performance of the gilts is "fuelled by higher break-even inflation rates…"

Reference is then made to the fact that "Across US, German, and Japanese markets the same lift in yields can be seen…."

This leads to the conclusion I reached in my post, cited above, "Thus, it seems that the cause of this latest bump in bond yields was kicked off by the speech of Prime Minister May in Great Britain and then spread through foreign exchange markets and then into bond markets, impacting some of the major economies in the United States and Europe."

In other words, world financial markets are more highly connected than ever and one cannot just look what is happening domestically to try and decipher what is gong on with bond prices and bond yields.

It seems as if the Brexit vote is causing waves across the globe… and one should exist that this will continue to be the case as the whole Brexit effort unfolds.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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