As UK government bond yields exploded higher in the aftermath of Prime Minister Truss’s mini-budget in September 2022, a market wag coined the phrase ‘The Moron Premium’ now widely used in financial media to reflect the higher interest rates the UK needed to pay to entice lenders back to the UK government bond market, or gilts for short.
Of course, Truss’s premiership fizzled out in less time than it took for a 3-month UK treasury bill, the historic and shortest maturity instrument issued by HM Treasury, to mature. But the damage inflicted on the market’s confidence has taken far longer to fade.
The Premium is really the spread, or yield differential between the UK and other bond markets. The long-term level of this spread between 10-year UK gilts and German bunds, as measured by the 200-week moving average, stood at 1% when Truss was selected to be PM by her party. This doubled very quickly, to reach a little over 2.25% before action taken by the Bank and efforts by the new PM and Chancellor to calm markets, saw the yield premium fall back again. It spiked again as UK core inflation reached 7% in 2023 before, finally, drifting back to the current level of 1.65%, reflecting UK yields of 4.15% and German yields of 2.5%. It remains, therefore, 0.65% above where it was before Truss entered No.10. A similar pattern emerges against US treasuries; gilts remain around 0.5% higher relative to their US equivalents than they were.
The paradox about this episode, however, is that it makes a repeat far less likely given the recency bias we all have to a greater or lesser extent. This posits that recent events have far more influence than older experiences, which means in policy setting, no government in the UK, whoever comes to power after the impending election, is going to repeat the same mistake again. Rather, they will keep fiscal policy tighter than would have been the case without Truss.
This argues that the long shadow of that episode should see the premium over other bond markets normalise back to long term averages. Therefore, gilts should outperform, both relatively and absolutely, given the macro-economic backdrop.
What’s the economic case for gilts?
Truss had the right intention, of course, which was to try and spark growth in the moribund UK economy. Since the eve of Covid in December 2019, the economy, as measured by GDP per head of population/capita, has shrunk by 1.2%. In absolute terms, it appears slightly better, having grown by 1.7% over the same period. But this reflects a surge in immigration, which has seen the population increase by 1.75 million people in the past three years. There is little doubt this is a poor performance internationally; the US, for example, has seen its GDP per capita grow by 7% since Covid.
Part of gilts’ underperformance has been the UK’s high inflation, especially for underlying or core prices. But recent research has suggested a strong link between the size of the energy shock a country experiences and the subsequent scale of the rise in core inflation. In other words, high energy prices impact not just headline inflation but permeate the entire economy, including the service sector. Crucially, the author (incidentally ex-Bank of England MPC member Gertjan Vlieghe) notes that this effect lasts for 14 months on average, dissipating and leaving core prices where they were1.
Furthermore, in a statistical quirk stemming from the OFGEM2 price cap, UK inflation is highly likely to reach 2% when April’s number is released on 22nd May. This will make the UK the first major economy to see prices back to target. And if Vlighe’s analysis is correct, core will follow, and UK inflation will end back at target. This prospective softening in inflation is supported by the deteriorating labour market. In the last print, the redundancy rate was at the highest since 2015 (excluding Covid), vacancies have fallen nearly 20% and the unemployment rate has risen by 0.3%. Wages, however, remain sticky but there can be little doubt these are a lagging indicator and given the fall in vacancies, should continue to soften.
Therefore, if growth is flat and inflation is likely to settle near 2%, why is the UK government having to borrow 10-year money at 4.15%? We would look to answer this question through an estimate of fair value. This suggests that, on a faster moving basis, yields should be closer to 3.5%, and on a slower moving basis 2.5%. This makes sense given where we think trend UK growth and inflation are – perhaps 1% and a little over 2%. Gilts are therefore compelling value and yields should fall at least 0.65% to reach our cyclical valuation, spurred on perhaps by the Bank of England, which sent a heavy hint today that official interest rates are finally on the way down, and probably more than the market expects.
The difference between fair value and actual is, at 0.65%, bang in line with the Moron Premium over German bunds. A coincidence perhaps, but with inflation about to hit target, the Bank about to embark on an easing cycle and the economy cruising at stall speed, it’s about time that the Premium was consigned to the history books.
1 CFMDP2024-07-Paper.pdf (lse.ac.uk)
2 Office of Gas and Electricity Markets
