Beware: a perfect storm is forming in the UK

As the BOE stays on hold, rate hikes will continue to feed through the UK mortgage market. Because UK mortgages rely on fixed rates for up to five years, the 515 bps rate hikes delivered until today have yet to hit this space. The current average mortgage rate on existing loans has increased from 2% in 2022 to around 3% today. As people move houses and refinance existing loans, we might see the average mortgage rate rising to 5% by the end of next year, tightening the economy further.

The pressure from the housing market will add to quantitative tightening (QT) and the BOE's higher-for-longer approach. Such a challenging economic environment will eventually lead to a deep recession or a tail event, forcing the BOE to make a U-turn on monetary policies. Although central banks can move aggressively to ease the economy during economic downturns, taking unnecessary duration risks may be dangerous until the crisis presents itself. That's why we favor a conservative approach and remain wary of duration. 

At the same time, we must remember that the Bank of Japan is still looking to normalize domestic monetary policy, building the case for Japanese investors' repatriation. As of this week, ten-year Japanese government bonds rose to the highest since 2013. Similarly, long-term rates are rising in the US, adding more pressure on UK long-term rates.

Short-term bonds provide shelter until the BOE is forced to make a U-turn.

While everything is set in motion for a bear steepening of the yield curve, it’s fair to highlight that such a move can quickly switch into a bull steepening in the event of a tail event or deep recession, which will steer the BOE away from its “higher-for-longer” stance. However, until such a scenario doesn’t materialize, we remain cautious and prefer the front part of the yield curve over a long duration.

Two-year Gilts still offer one of the highest yields since the 2008 global financial crisis. They have a modified duration of 1.9%, hence offering flexibility to investors who may want to enter another position not far in the future.

Despite long-term yields being on the rise, it's crucial also to consider 10-year Gilts (GB00BMV7TC88) and look at them from a risk-reward perspective. Entering at 4.45% today and assuming a holding period of a year will provide a loss of -2.38% if yields rise by 100bps, but they will return 11.5% if yields drop by 100bps in the same period. While the safe haven will provide protection against a tail event, we are wary of adding more duration until the macroeconomic backdrop becomes clearer. 

When looking for a pickup over Gilts, buy-to-hold investors may consider the investment grade corporate space, which is also offering one of the highest yields in more than a decade. Below is a list for inspiration purposes.