Stormy week for Gilts; Less negative relationship between equity and fixed income drives portfolio risk higher
Week of June 16
Last week, Gilt yields took a choppy ride, starting with an 8-basis point surge in the 10-year benchmark rate on Tuesday after the Office of National Statistics announced that consumer price inflation had risen to 2.9% in May, its highest level since April 2012. Economists had expected 2.7%, the same increase as had been recorded in the previous month.
The sudden jump in inflation was expected to put pressure on the Bank of England (BoE), as this latest reading is just 0.1% below the upper boundary of the Bank’s target range (one percentage point either side of 2%). If the growth rate goes above 3%, the governor of the BoE is required to write an explanatory letter to the Chancellor of the Exchequer. In a prompt reaction to the consumer price surge, three of the eight members of the Bank’s rate-setting monetary policy committee voted for an interest rate hike at their monthly meeting on Thursday, which sent Gilt yields yet higher by another 11 basis points.
At the same time, a slowdown in weekly wage increases from 2.1% to 1.7% reported on Wednesday indicated negative real earnings growth for UK workers. This fueled concerns about economic growth, which in turn sent the 10-year rate down by 11 basis points, while further small decreases on Monday and Friday meant that it ended the week only 2 basis points higher in total.
On the other side of the Atlantic, the 10-year Treasury rate fell by 4 basis points over the week, seemingly unimpressed by the Federal Reserve rate hike on Wednesday. The central bank’s decision had been widely anticipated and market activity at the long end of the US curve focused more on a weaker inflation reading published on the same day, which showed that consumer prices had actually fallen by 0.1% month-on-month.
In Axioma’s global multi-asset class model portfolio, short-term risk rose further by 0.31% to 4.56%. The increase was partly driven by higher FX rate volatility, but also by a further lessening in the negative relationship between equity and interest rate factor returns. It is therefore not surprising that the biggest addition to risk of 0.15% was observed for non-US government bonds, followed by international corporates and global inflation-linkers, which each added another 0.10% to overall portfolio variation. It is also worth noting that the contribution from gold increased by 0.08%, as the precious metal became less correlated with US Treasuries and saw its negative interrelationship with the American stock market erode as well.
The fact that less equity risk was offset by fixed-income assets also meant that there was not as much diversification from the corresponding risk factors. Assuming perfect correlation between risk types, total portfolio volatility would have been 7.70%, down from 7.89% the week before due to lower equity standard deviation. However, this was outweighed by a squeeze in the diversification effect, from -3.64% to -3.14% in the latest week.
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