DMO’s Stheeman: Market must decide what works
The DMO today outlined a new era of higher gilt issuance with an emphasis squarely on upsized shorter and medium-dated nominal gilt supply in the near-term that will have to be tackled by a combination of the Treasury, the DMO and, more importantly than ever, the GEMMs.
The market reaction to both the mini-Budget from the Chancellor and the DMO's revised remit for 2022-23 has been historically sharp, with 5y gilt yields leading the pack via an at times more than 55bps sell-off (currently the 5y yield is +45bps at 4.01%).
DMO chief Sir Robert Stheeman told Total Derivatives that “what we are seeing today is the market adjusting to what it sees as the right levels. That is happening in front of our eyes and at high speed. The price shift of the last 48 hours shows just how efficiently and quickly the market adjusts to changed circumstances nowadays.” Five year gilt yields rose by 18bps yesterday and are up around 90bps over the past week.
And, he continued, “the story of the last 20 years, and particularly the last 14 years (since the financial crisis) is that the market has proven that it will adjust and, while liquidity on a Friday and in the immediate aftermath of a significant remit revision, is likely to be adversely affected the gilt market has previously always shown it will adjust to meet changing circumstances very efficiently.”
The DMO today announced a revision to the fiscal 2022-23 remit that sees its financing requirement increase by £72.4bn to £234.1bn, (with gilt sales accounting for £62.4bn and Treasury bill sales £10.0bn) and Stheeman said today that “the remit having been revised in the way it has tells the market exactly where that funding will come.”
Namely in the shorter and medium sectors of the nominal curve. RPI-linked gilt issuance is only set to rise by £300m from its most recent position, to £21.2bn, and Stheeman noted that linker issuance “has declined in percentage terms (versus nominals) which reflects the fact that the size of index-linked auctions is always smaller than nominal issuance. When the Government needs significantly to deliver a large increase the in size of its financing programme in a short period of time the focus inevitably falls on supplying in the short and medium parts the nominal curve.”
Which is reflected in today’s biggest ever leap in 5y yields ever recorded. Linkers “will remain a core part of the issuance programme,” he added.
That programme though remains in a state of fluidity, with Stheeman noting that the forecast of future financing requirements will likely change again after the next OBR report that will presumably emerge later this calendar year (for more on that see next section).
But in the short-term, Stheeman emphasised, supply changes are not going to be wildly drastic. In the coming Q3 quarter, he noted, “there are four more auctions and one long syndication, a new current coupon 2038 maturity which the DMO is keen to have because its new coupon will reflect the changes (in yields) that we’ve seen recently.”
He added, “that the definitive gilt operations calendar for the next quarter will be published next Tuesday.
Excessive market reaction to issuance news?
Whether in cash or percentage terms, today’s market reaction is arguably too large to be driven solely by the need to make room for the market to digest an additional £62.4bn in gilts over the next six months.
As discussed, the changes - shown below - are large and skewed to the front end but the total (plus an additional £10bn in T-Bills) is not far from the Bloomberg consensus forecast of £60bn, and its below the highest market forecast of an £80bn increase:
- Short-dated gilts: +£31.2bn to £73.5bn
- Medium-dated gilts: +£17.5bn to £46.6bn
- Long-dated gilts: +£8.4bn to £47.0bn
- Index-linked gilts: +£0.3bn to £21.2bn
- Unallocated: +£5.0bn to £5.6bn
- Total gilts: +£62.4bn to £193.9bn
- T-Bills: +£10.0bn to £40.2bn
Instead, the massive jump in yields seems to reflect a mixture of price discovery, illiquidity and lost policy credibility. For the latter, there are no OBR forecasts of the outlook for the medium term deficit and debt, no discussion of tax or spending measures to bring the deficit back down, and no analytical backing for hopes of faster GDP growth. A higher risk premium would also explain the pressure on sterling, which is down 2% against the dollar.
DMO CEO Stheeman suggested that the macro-climate and the concentration of enhanced supply in shorter-dated gilts were the key reasons for the gilt selloff. Indeed concern about the BOE MPC’s reaction to today’s £72.4bn fiscal ease has pulled red SONIAs 48-58bps (!) lower and the futures strip is now pricing a 5.5% BOE rate in Dec23 and BOE rates above 5% until Sep24.
Meanwhile although the OBR’s forecasts are still locked away in a safe, the Treasury’s own estimates of the mounting cost of the tax cuts announced today over the medium term, point to big increases in gilt issuance further down the line barring a growth surge. Kwasi Kwarteng may have Nigel Lawson’s tax-cutting Budgets in sight but the Lawson era of the late 1980s also saw an unsustainable inflationary boom that ended badly.