Rising Yields: Gilty Until Proven Innocent?

Added: 2026-05-21

[00:00:00][music] >> Welcome to Money Happy Returns, where we aim to make you a better investor. I'm Roman. And I'm Michael.

[00:00:09]With gilt yields at their highest since 1998, has the bond market finally lost patience with Britain? We ask whether this is really a UK problem and whether the Bank of England is pouring petrol on the fire. I want to know whether gilt yields above 5% are a bargain or a trap.

[00:00:26]And in today's dumb question of the week, >> [music] >> what's the difference between RPI and CPI?

[00:00:34]Okay, let's get into it. So, we took a couple of weeks off, Roman, and we've started getting increasingly desperate emails from people saying, "Where are you guys? How can I go on without knowing what Roman thinks about bonds?"

[00:00:46]Now, you should be able to guess, but let's cover it anyway. So, the bond market is in a bit of a spin right now.

[00:00:53]What's going on?

[00:00:54]Well, what we've seen is a yield curve move upwards, and a lot of it is not interesting, I have to say. It's just a mechanical response to higher energy prices, and that's global. Whether you live in the UK, Japan, Germany, or the US, you'll see the yield curve shift upwards.

[00:01:12]The real interesting stuff happens at the boundaries, at the kind of margins of the yield curve movements, the kind of second order effects. Those are what's interesting.

[00:01:21]But before we get on to the second order effect, let's go first order. What's actually happened to yields in the last few weeks?

[00:01:27]So, just looking at the yield curve right now compared with where it was 2 weeks ago, that's what's happened. It's happened across the whole curve, so that everything's moved upwards in terms of yield. Whether you're a 50-year bond or whether you're a 1-month bond, the yield has increased. Give us a sense of the different durations, then.

[00:01:46]So, the 10 years what most people look at when they think about the yield curve, it's the most liquid part of the curve, and that's moved up by about 20 basis points. That's 0.2% from about 5% to 5.2. So, that's the move that we've seen at the belly of the curve. But, even if you look at the 40-year point, it's roughly the same.

[00:02:07]So, we've seen an increase in yields by about 20 basis points, a little bit more than at the short end. I mean, the headlines have been dominated by the long end because the 30-year gilt yield hit the highest level since 1998.

[00:02:21]Now, that sounds shocking, but what you've got to remember is the path we've been on because it's not just about a recent event which has caused this. What we've done is we've moved back to a normal-looking yield curve. So, if you compare with the zero interest rate period, of course, it's going to look crazy. But, this is a normal yield curve. So, 5% at the long end of the curve is absolutely normal.

[00:02:45]But, everyone was hoping that zero interest rates were a new normal. We could just have free money forever.

[00:02:50]Seems like we can't, but I want to know how much of this is a UK only problem.

[00:02:55]So, we have seen yields across the world move up.

[00:02:58]So, for example, the US 30 years back above 5%. The German Bund, you look at the 30 year there, that's a 15-year highs. And Japan is quite shocking one.

[00:03:08]So, their 30 years at all-time highs around 4.2%.

[00:03:12]But, have we had it worse in the UK?

[00:03:14]Yeah, we have. I think we have seen our bond curve move more than some of the other countries. And certainly, if you look at the absolute yield, it looks pretty high.

[00:03:23]There was a really nice article in the FT by Toby Nangle, who I hope one day we'll be able to get on the podcast, but he's actually done something really interesting where he's tried to tease out the different components of the UK yield and compare that with different countries.

[00:03:38]And what he was joking about was the premium, which if you remember, was the additional yield that we paid in the UK as an outcome from the crazy period under Liz Truss when we saw gilt yields spike massively due to the Conservative government's unfunded tax cuts at a time of very high inflation.

[00:04:00]So, not only was it inflationary, it was unfunded, and furthermore, they decided to fire all the experts and just go their own way, which bond markets really didn't like.

[00:04:12]Yeah, people listening to this might say, but yields now are higher than they were during that mini-budget episode.

[00:04:18]But, I guess what characterized that period was a really sharp pickup in yields.

[00:04:24]And that kind of doom loop dynamic, where pension funds were being forced to sort of a fire sale of their assets, and the Bank of England had to step in, and Liz Truss had to step down.

[00:04:34]But, to go back to the premium, I think it's hard to argue that the UK is the only country that ever suffers from moronic leadership, right? That's not a UK problem.

[00:04:45]So, how much of the yield curve move is a UK problem?

[00:04:49]Now, one way to look at this is in terms of absolute levels, so you could say that the yield is 5.2% at the 10-year point or whatever, or you could look at the changes over some period of time.

[00:04:58]And that's often the way people analyze yield curves. They look at the shifts.

[00:05:02]And if you look at the size of the UK shift, it's about twice that of other developed market countries, such as Germany, for example.

[00:05:10]And that's over the last month.

[00:05:12]But, what Toby Nangle's done, which is really quite beautiful, is try to strip out the different factors which are driving that. So, how much of it is due to currency? How much of it is due to interest rate expectations?

[00:05:26]So, what he's done is he's stripped out the currency effect, and he's stripped out the rate expectation effect using a variety of swaps.

[00:05:36]So, what he's got is effectively the gilt yield curve transformed into something like a US dollar curve, such that the difference between the two is due to the risk premium. Maybe it's also due to things like illiquidity.

[00:05:49]Go on then, put a number on it for us.

[00:05:51]Well, as Toby puts it, he says there's no screaming plonker premium. There isn't much difference at all once you strip out those effects. There is a slight increase relative to where we were a few weeks ago or a month ago.

[00:06:04]And I think a large part of that is due to politics, but also due to the UK's very high sensitivity to energy prices.

[00:06:12]So, there are reasons driving it. It's just not necessarily the market's fear that our leaders might not be up to the job.

[00:06:19]Because if you just looked at the raw move in yields, it looks like roughly half of the UK's premium is coming from specific factors in Britain, and half is just global beta, if you like.

[00:06:32]Yeah, and if we compare us with someone like Italy, so BTPs are Italian government bonds, their move has been about 25 basis points less than ours.

[00:06:42]So, that's roughly the political premium that we've added on top because of what's going on in the UK right now.

[00:06:48]What we have seen, interestingly, is sterling sell off a little bit at the same time as our yields are rising, which always makes me fear that we're treading the line of an EM country. Is that just going way too far?

[00:07:01]I don't think it's that bad. I mean, if you look at the UK's sterling strength, well, it hasn't moved a lot. That's another one of the graphs that Toby quotes. And I think he's right to say that it hasn't moved much. But you're right, it has weakened.

[00:07:15]Yeah, I think it's moved around one percentage point versus the dollar or the euro over the last month. Not huge, but notable, I guess, in terms of developed market currencies.

[00:07:26]But is there an elephant in the room here?

[00:07:30]Now, in macroeconomic terms, the elephant is always the central bank.

[00:07:34]And the Bank of England is doing something quite different to what other central banks are doing. Not really in terms of monetary policy, but in terms of how it's managing its balance sheet.

[00:07:44]So, most of the big central banks are shrinking their holdings of government debt, but they're doing it in a passive way. As bonds mature, they're just not reinvesting the principal.

[00:07:55]Whereas, the Bank of England is actively selling some bonds into the market.

[00:08:00]Well, you say what we're doing is different, but remember that what Kevin Walsh has said is that one of his top priorities is shrinking the balance sheet. But, given that he's taking over as chair of the Fed at a time when inflation's spiking, you just look at the PPI numbers from the US. It is absolutely shocking. Well, if that's the case and he's going to be shrinking the balance sheet into that or even talking about cutting rates, well, good luck with that. Yeah, I think it would be odd if the Fed looks at what's happening to yields in the UK and says, "Oh, let's copy what they're doing."

[00:08:33]But, I think the way the Bank of England's doing it is really sensible, which is to say, "Look, here are three scenarios. We're going to look at each one. We're going to assign our own individual probabilities of which scenario we're entering, and then we'll work out our policy based on that kind of probabilistic analysis, the scenario analysis."

[00:08:53]The scenarios were really wide-ranging though in terms of outcomes. Covered all bases really.

[00:08:58]Yeah, so you've got A, B, and C are the three scenarios. B is the kind of middle path where oil prices stay elevated for about 3 months, maybe, and then start to fall.

[00:09:08]A is a short, sharp shock, and then C is an absolute horror show.

[00:09:13]Now, personally, I say it's moving more towards C than B.

[00:09:17]But, certainly, the Monetary Policy Committee members were very much veering towards B.

[00:09:22]Except for one, of course, which was Huw Pill, and he voted to actually increase interest rates right now because he thinks the process of having these anchoring of expectations has already kicked off, and you need to stave it off by preemptively creating some kind of interest rate increase.

[00:09:41]Well, inflation has ticked up to 3.3% largely driven by energy prices. And as we're recording this today, we've seen some really weak economic data out of the UK. Unemployment's up to 5% and payrolls have fallen by 100,000 in April.

[00:09:56]So, it's looking stagflationary. You have to say that, don't you?

[00:09:59]Oh, yeah. Weak growth and higher inflation.

[00:10:03]Now, that does some of the Bank of England's work for it, because the fact that the yield curve's moved up is essentially tightening policy for them.

[00:10:11]They don't have to do anything.

[00:10:13]And also taking money out of people's pockets because they have to pay more for fuel and they have to pay more for energy overall. Well, that also reduces demand and it slows down the economy.

[00:10:25]So, in a sense, we have an auto tightening in the UK anyway.

[00:10:29]And of course, mortgage rates have gone up because swap rates at the short end have gone up.

[00:10:34]Yeah, which has confused a lot of people. I made a video specifically about this cuz I think it is confusing.

[00:10:39]You know, why should energy prices affect what my mortgage is going to cost? But of course, that's the case.

[00:10:44]You know, that is the way it works.

[00:10:46]Because the market is expecting rate hikes over the next 12 months.

[00:10:51]Yep, and yield curves have got to move up as a response to that. So, that's that's why I think a lot of people are feeling this pain.

[00:10:59]Suddenly, macroeconomics isn't a boring subject, which is a dry economic topic.

[00:11:04]Well, it affects your daily life.

[00:11:06]But is the Bank of England making it worse for the public finances because the long end is rising perhaps more than it otherwise would by them actively selling bonds? Why are they the outlier here?

[00:11:18]I think in the UK, one of the issues is that we have longer dated debt. So, if we were to just let the debt roll off as the US has, then that would take take quite a long time. I did an analysis of this a while back and I think it would take, you know, a very long time to reduce the size of our balance sheet by half. I think it was like 5 years longer than the US from memory.

[00:11:42]Right. So, kind of the structure of the debt means that we have to get a move on in terms of actively selling it.

[00:11:49]But why sell it in the first place? Is there a need to do this?

[00:11:53]I think one of the issues here is to do with being ready for the next crisis because if you want to do QE to put it to be a shock and all thing, well, you've got to have some dry powder.

[00:12:04]And at the moment we're still reeling from the last crisis. So, I think getting the balance sheet down isn't a bad idea.

[00:12:11]I am worried about the fact that it might be distorting markets. Now, the Bank of England, of course, is all over this. They speak to the gilt-edged market makers, the gems. They speak to the market participants. So, they should know exactly what's going on. They know about the liquidity of the market. They know much better than I do.

[00:12:29]And they claim that there's no distortion. But I think to some extent it is just common sense that if you've got this huge holder of gilts and they're selling, well, how would that not affect yields? It must.

[00:12:42]I think the bank acknowledges that it does, but just that the effect is small.

[00:12:48]And they say the market is still functioning.

[00:12:50]The bid-to-cover ratio at gilt auctions is typically quite good. And market liquidity has not run into any problems yet.

[00:12:58]But I have started to see noise in the press saying, "Why is the Bank of England doing this?" Partly because of the effect on yields, but also because the way that QE and now QT was structured in the UK, there was an indemnity from the Treasury. And because the bank is now selling these bonds at a massive loss, effectively the British taxpayer is being forced to send a check, a big check, over to the Bank of England to cover the losses.

[00:13:25]Now, what we don't talk about is the fact that when we were doing QE, we were getting a big check in the other direction effectively.

[00:13:33]Yeah, it's crazy. If you look at some of these prices at the long end of the curve, like TR 73, our longest dated gilt, which matures in many, many, many years. I'm not going to see this one mature.

[00:13:44]That's currently trading at around 28 pounds. Now, that's out of 100.

[00:13:50]So, it's almost like one of those post meme crash stocks when you're looking at the prices of these things.

[00:13:56]I guess the weird thing is if you believe the Bank of England's scenario B that you mentioned, that moderate middle path, it would suggest that we're at the peak in rates now, more or less.

[00:14:09]And that yields across the curve should fall in the coming years.

[00:14:12]If that's the case, why sell at massive losses now?

[00:14:17]Bailey's kind of saying one thing, but doing another.

[00:14:20]Or do they just not care about the path of yields? That's a separate question.

[00:14:25]I think from their point of view, it's all about achieving their mandate, and their mandate is price stability. So, if shrinking the balance sheet right now is the right way to achieve those goals, which clearly they think it is, then I think they're not going to be too worried about the price they sell at because that's not something they can control. It's not really their job to make money on these trades.

[00:14:48]But, I suspect a kind of secondary consideration in the back of their minds is that they can't make life unbearable for the UK government in fiscal terms.

[00:14:58]But, there's a weird thing. Like, even if they thought, "Okay, maybe we should stop active sales now, just for a bit.

[00:15:03]Pause it for a bit." That's going to smell like fiscal dominance a little bit to the market, isn't it? It's going to look like the Bank of England was pressured into doing something by the Treasury.

[00:15:13]Look, they can't ignore the effects of monetary policy on growth. There's no way they can, even though their mandate's only about inflation. Of course, they have to about growth because indirectly that also affects inflation.

[00:15:26]But are they folding to some kind of cabal from Westminster which is putting pressure on them? I >> [laughter] >> I really don't buy that. They take independence very seriously and I think the government still takes independence very seriously, at least this government.

[00:15:41]Okay.

[00:15:42]Do you think the Bank of England will pause active bond sales, let's say by the end of the summer, or at least, you know, shrink it to a nominal amount, or will they just carry on with what they're doing?

[00:15:52]Well, the Fed has and if you look at the size of their balance sheet is actually increasing at the moment.

[00:15:58]So, I wouldn't be surprised if they did.

[00:16:00]I think although they're saying, "Look, we're not distorting the yield curve by selling these bonds." They know that this having some marginal effect and that's causing pain to the Exchequer and it's causing pain to the UK.

[00:16:14]I think another thing that's under appreciated about the UK's public debt is that relative to its international peers, a lot of it is index-linked. It's linked to inflation. I think it's around a quarter of gilts currently get uprated for inflation every year.

[00:16:29]Yeah, because we had all of these companies which were desperate to get inflation-linked protection, life insurers, some pension funds, but some of those have stepped back from the market, companies like DB funds which are being wound down. So, we are going through this period of transition as we have less inflation-linked debt, but you know, I quite like these inflation-linked bonds. I think that they're all quite useful as a part of a toolkit for people in retirement.

[00:16:56]But we have a lot of them.

[00:16:58]So, according to the FT, the UK has about a quarter of its debt repayments linked to inflation, which is more than double the amount of Italy, which has the second highest proportion of any large economy at 12%. So, we have sort of doubled down on index-linked debt.

[00:17:14]Whether that's going to pay off just depends on the path of inflation, really.

[00:17:17]Yeah, I guess if we do get weaker growth, that should push inflation down.

[00:17:21]Our history for inflation isn't great, it has to be said, relative to Europe or to the US.

[00:17:26]So, hopefully this debt isn't going to be a rod for our own backs.

[00:17:30]I guess these are more long-term concerns, aren't they? They play out over decades based on average inflation and growth and things like that.

[00:17:39]But, at the moment, the market seems hyper-focused on what's going to happen in the short term.

[00:17:44]And once again, we have a question of who is going to be leading the country.

[00:17:48]Do you think the market looks a little jumpy at the prospect of Andy Burnham potentially becoming PM?

[00:17:54]Oh, absolutely. If you look at the yield curve movements, they have responded to his prospect of becoming Prime Minister.

[00:18:01]Now, initially, he was talking about having a separate pile of debt specifically for defense.

[00:18:06]And that wouldn't be counted against our debt-to-GDP ratio, which is just bonkers, you know what I mean?

[00:18:11]>> [laughter] >> Why would that not be part of the debt?

[00:18:14]>> We don't like to do that with our household budgets, wouldn't we? Oh, this bit doesn't count. I'm just going to circle out my daily avocado toast budget.

[00:18:22]And that freaked markets out, right?

[00:18:23]That Of course it did, because it was crazy to make that distinction.

[00:18:28]Realizing that, I think he's pedaled back on that, and he said, "Look, I am going to care about debt-to-GDP ratios."

[00:18:35]You can't really be in power nowadays in the UK and not take the bond market seriously. That was the fallout from what happened to Liz Truss.

[00:18:44]Yeah, the market definitely doesn't want a lettuce of the left, if you will.

[00:18:49]Where it's not about tax cuts, but it's about spending hikes.

[00:18:52]But, if he's not going to change the fiscal rules, as he's now said, but he does want to presumably spend more, cuz he doesn't want to just repeat exactly what Starmer is doing, then I guess that means raising more taxes, doesn't it?

[00:19:04]Yeah, there's no other choice. So, that's >> [laughter] >> that's what we're looking at. And that can be negative for growth, it often is negative for growth.

[00:19:12]So, that's a very difficult situation that the UK's going to find itself in.

[00:19:17]Do you trade off growth or inflation?

[00:19:20]Which of the two is it that you choose?

[00:19:23]A little from column A, a little from column [laughter] B, I reckon.

[00:19:29]But, it'll be interesting to see what happens if we do get this shift in leadership of the Labour Party to see what they actually do.

[00:19:36]Will they start spending like drunken sailors or are they going to stick to these debt-to-GDP rules which Rachel Reeves came up with? Or will there be a new tax and spend Chancellor?

[00:19:47]I don't think they can go way off piste because the bond market will fight back if they do that.

[00:19:53]It's already signaling, I think, that it's ready to bring out the big stick if it needs it. And I'm just looking now on the betting markets. And there seems to be a 75% chance that Keir Starmer is out by the end of the year.

[00:20:07]But, I think even looking beyond the Labour Party's turn, then if we think about what comes next, it's very likely, based on recent polls, to be a Reform government.

[00:20:18]And I think gilt markets are also concerned about what that government spending will look like. Cuz they do seem to have a lot of policies which are about tax and spend.

[00:20:27]A lot of their policies will be expensive.

[00:20:30]I don't know. Things can change quickly in politics. The election's still a fair few years away.

[00:20:35]But, it does beg the question of what are markets actually pricing into the curve right now.

[00:20:40]There's obviously uncertainty about who's going to be running the country and what their policies are going to be.

[00:20:45]We've mentioned there's uncertainty about growth. It looks weak. Which would usually push the long end of the curve down.

[00:20:51]But, that's not happening. So, presumably, there's inflation being priced in.

[00:20:55]Or is it the fact that term premium has come back in a big way?

[00:21:00]So, let's cast our minds back to 2022 just to imagine what the yield curve would have looked like. Well, it was essentially downward sloping rather than upward sloping. So the term premium was negative in 2022 in November, which is a very weird situation because you're actually paying to take more risk with your gilts, which seems like a bonkers situation.

[00:21:25]Fast forward to today and you've got that normal upward sloping yield curve.

[00:21:29]So the term premium is now positive.

[00:21:32]And is that a reflection of the greater uncertainty we have? As in people want to be compensated for taking duration risk again.

[00:21:39]Which is odd because at those times, you know, in 2022, it was very clear that rates at some point were going to go up.

[00:21:46]Whereas now that we've got a kind of semi-normal yield curve, you wouldn't expect markets to be pricing in such increases in interest rates that we saw in 2022.

[00:21:57]Is there a fear of fiscal dominance?

[00:22:00]Are bond investors having to price in a possibility that the UK political system is just incapable of delivering spending restraint or tax rises that stabilize the public finances over the long term?

[00:22:15]Especially given what's happening with demographics and an aging population.

[00:22:19]Is it just politically impossible to balance the books?

[00:22:23]I'd say that markets are pricing in very hefty inflation all the way out to about 45 years. So break-evens at the moment are something like three percentage points at the long end, about four and a bit percent at the short end.

[00:22:38]Now that's what's priced into the curve.

[00:22:40]You know, what inflation rate would you expect over this period of time? So what we're expecting is high inflation initially due to presumably supply shock effects due to the straight at home hours. And then further out, you get a normalization down to 3%, which is still far higher than the 2% Bank of England target.

[00:23:01]It's a slightly false comparison given that the Bank of England is targeting CPI and index-linked gilts at least currently track RPI. But anyway, that's for the dumb question.

[00:23:13]Maybe something we should address is whether there's a disconnect between what the bond market seems to be expecting and what the stock market is doing because the stock market is just carrying on, isn't it, saying "Times are good. Earnings are growing rapidly in the US." And these companies seem to be worth trillions of dollars.

[00:23:33]Well, certainly for a very narrow part of the US market, that's true. So, if you look at semiconductor companies, they're on fire. You know, if you look at how they've moved since April the 20th to May 14th, it's just been unbelievable how far they've risen.

[00:23:48]They're up by around 20% over that period of time.

[00:23:52]And memory chip stocks is just insane.

[00:23:55]>> [laughter] >> If you look at the stock price chart for SanDisk, >> [laughter] >> it's like the graph just looks wrong.

[00:24:02]It's up 3,337% over the last year.

[00:24:08]Gosh. That's get-rich-quick stuff, isn't it? It's software that's languishing, and that makes up a larger proportion of the S&P tech sector.

[00:24:17]So, if you combine all those factors, a very narrow leadership of the S&P, which is the largest market in the world, and a narrative which is maybe starting to become more realistic in terms of the expenditure to get a certain level of growth in earnings, that doesn't paint a great picture for the upside from where we are today.

[00:24:39]But if the US 10-year is above 5%, surely that has to weigh on the stock market.

[00:24:45]Particularly as a lot of the funding for the hyper-scaling has come from the bond market rather than from the equity market. So, if they'd have raised money through some kind of share issue, yeah, that would have been fine. But the cost of capital goes up with the risk-free rate.

[00:25:00]Even if the credit spreads are really tight, the all-in cost of funding will still be higher for those companies once they have to roll over that debt.

[00:25:08]So, yeah, I think it's eventually going to weigh on these companies, what are currently the success stories, if they don't get really big boosts to their top lines from this investment in infrastructure.

[00:25:20]There was an article in the FT this morning. Investors warned of correction risk as high-flying stocks defy bond gloom.

[00:25:28]And in that article, there was a quote from one analyst who said, "There's an incompatibility between having equities at all-time highs, credit spreads so tight, high bullishness, and at the same time interest rates and energy markets pricing in a lasting impact on the economy."

[00:25:44]And we've still got this crazy sideshow, which is Trump coming out and saying I'm going to bomb Iran if they don't come back to the negotiating table, and then chickening out. I mean, markets surely still don't believe all of this narrative.

[00:25:57]But in the meantime, you can buy a UK gilt that locks in a yield of 5.7% for 30 years.

[00:26:06]That is a lot better than really any time in the last few decades. Is that kind of like the bargain of the century, or is that a value trap?

[00:26:14]Well, personally, I think it's based on what you need. If you need something which gives you that return, that coupon, whatever it is, and that total return, and you are willing to hold it to maturity, which for a 30-year bond would be quite an ask.

[00:26:29]That does seem pretty attractive, I think.

[00:26:32]Well, it depends what you think inflation's going to do, doesn't it, over the medium term.

[00:26:36]So, if we subtract the real yield, which is about 2.5, from that nominal yield, you get a break-even of about 3.4%.

[00:26:45]Now, that's pretty chunky. And that's going to be inflation for every year for the next 30 years, which would be a catastrophic performance from the Bank of England, it has to be said.

[00:26:56]Yeah, although inflation has averaged 3% since 2010.

[00:27:01]But that of course includes the period of extremely high inflation post COVID.

[00:27:05]Now personally, I don't go that far out on the yield curve. I just hold to maturity, so I'd be looking at the zero to five-year part of the curve. And there too, you've got some really attractive yields.

[00:27:16]So at the five-year point, you could lock in 4.6% every year over the next five years.

[00:27:21]And the real yields there are also not crazily low. We're talking about roughly 0.7. So still positive.

[00:27:30]I suppose the risk of going too far out on the curve, if you're not sure that you'll be holding to maturity, is that any further rise in yields will result in quite a big drop in the mark-to-market value of your bond, because the duration is long.

[00:27:44]So what's the duration for a 30-year bond? Something like 18 years is it roughly? Yeah, a little bit less than 20 maybe.

[00:27:53]Which would mean that if yields at that part of the curve rose by a further one percentage point, the value of your bond would drop by around 18%.

[00:28:03]It's going to be volatile potentially.

[00:28:05]Oh, man's crypto, that's what we call it. And uh people do like to speculate on it, but that's what it is. I think for things you are not going to hold to maturity, the mark-to-market change in the price of the bond is going to be very important for your total return.

[00:28:20]Okay, last question before we wrap it up.

[00:28:23]What could cause yields to drop from here unexpectedly?

[00:28:28]Well, I think if we went to scenario A from the Bank of England, which was a short sharp shock in terms of energy prices, well, if that were to happen, then the Bank of England could look through this energy shock and go back to its process of rate cuts fairly quickly.

[00:28:43]So a resolution to the Iran war, oil falling back below $80 a barrel and maybe it gives the Bank of England room to ease again.

[00:28:52]And if they do do something surprising with a balance sheet, in other words, they stop selling bonds, they stop selling gilts, then that could also have that effect.

[00:29:00]I guess this isn't the central case. The central case is what's priced into markets right now.

[00:29:05]But who knows? Things are uncertain right now. You never know what Trump's going to do in Iran. And bond yields do seem to be moving alongside energy prices really.

[00:29:13]And of course, the other effect is political risk in the UK. What if we were to get a government that suddenly managed to work out how to manage growth, maybe not make it surge, but certainly keep inflation under control?

[00:29:27]Perhaps by having a better energy policy because a big proportion of our inflation in the UK comes from our weird price cap methodology. And there is talk about changing that already.

[00:29:38]So perhaps we'll be shocked by a competent government.

[00:29:42]Yeah, it could happen.

[00:29:43]There's a lot of things that can be fixed. Planning policy, policy, fiscal policy more broadly.

[00:29:49]And you know what they say?

[00:29:51]Fix the roof while we're in the middle of a downpour. Isn't that the phrase?

[00:29:54][laughter] Now, we mentioned the Bank of England's three scenarios. We talked about that in our weekly market roundup, which is a humorous approach to markets and economics, which makes it much easier to understand, I think. You can sign up for that free. Just go to pensioncraft.com/newsletter.

[00:30:13]Okay, today's dumb question of the week.

[00:30:16]What's the difference between RPI and CPI?

[00:30:21]Well, RPI stands for retail price index, CPI stands for consumer price index, and they are calculated in different ways, and different things go into the two indices.

[00:30:32]The reason why it's kind of important is if you buy inflation-linked bonds in the UK, they're currently indexed relative to RPI. And this is a measure which the Office for National Statistics absolutely hates. They almost wants to refuse to publish it. And from 2030 onwards, inflation-linked bonds will move to being indexed by CPIH, which is a housing market and general inflation basket version of CPI.

[00:30:59]And I guess the broader reason why this matters is because RPI generally runs around a percentage point higher than CPI.

[00:31:09]So, you can see why the government would want to link things it pays out to CPI and would quite like to link things it collects to RPI.

[00:31:19]So, what's the difference then? Why is RPI a higher number than CPI typically?

[00:31:26]So, part of it is what's in the basket.

[00:31:28]So, RPI includes housing costs like mortgage interest payments and council tax. CPI doesn't include those.

[00:31:36]CPIH does include housing costs, but um possibly more sensibly, so it uses something called owner-occupiers' rental equivalent, which is basically how much would an owner have to pay to rent their own house, if you want to think about it like that. Yeah, the Fed often talks about that measure when it's talking about house prices in the US and whether they're overpriced.

[00:32:01]Weirdly, there's also a mathematical difference because RPI uses something called an arithmetic mean, where you add up the numbers and you divide by the number of things you got. CPI uses a geometric mean, which is always less than the arithmetic mean. And to be clear, that use of the geometric mean with CPI is the international standard.

[00:32:22]So, it's not like the UK is fiddling the books on inflation. But the difference in maths does account for a big chunk of the difference between the inflation measures. So, I read a paper from the government's Actuary's Department. It was pretty dry, I have to say, but it said that of the expected 1.15 percentage points a year difference, around 0.9% is due to the calculation method, and then 0.25% is due to other differences like the treatment of housing costs.

[00:32:57]Which is an amazing thing if you think about it. Just a change in one formula can make a massive difference, billions of pounds in the cost of servicing inflation linked debt.

[00:33:07]There's also other weird things with RPI where it excludes some people from the measure. It excludes the highest income households. Did you know that? I didn't know that. I think it's something like the top 4% of earners just don't count cuz they have atypical spending patterns.

[00:33:23]It also largely excludes pensioners who rely on state benefits for the majority of their income, whereas CPI covers everyone.

[00:33:32]I don't think it causes a huge effect, but it is a difference in how the two indices are put together.

[00:33:37]But all of this will be a moot point from 2030 onwards because we're going to switch my RPI to CPIH when we look at the uplift of linkers.

[00:33:46]So, if you look at the yield curve beyond my 2030 point, presumably the market's pricing in that switch because we know it's going to happen.

[00:33:54]Are they going to compensate the current bond holders?

[00:33:58]I think you know the answer.

[00:33:59]>> [laughter] >> A big fat no.

[00:34:03]Now, you're probably thinking where does this 2030 come from? And it's kind of an interesting answer. It's linked to the maturing of three specific index linked gilts.

[00:34:14]Now, these were issued with specific provisions in their prospectuses, which would give holders protection against structural changes to the index.

[00:34:23]And the longest dated of those three gilts matures in 2030, July 2030.

[00:34:30]So, it's the small print of the bond issuance which nobody read, >> [laughter] >> but it's saving the bond holders for the time being.

[00:34:38]Thank you for joining us for many happy returns. Keep sending us your questions, no matter how dumb, at [email protected].

[00:34:46]And do remember to check out pensioncraft.com for all the information about our membership, courses, and investment coaching options. Many Happy Returns is a PensionCraft production, co-hosted and executive produced [music] by Ramin Nakisa and Michael Pye. This podcast is for informational and entertainment purposes and is not financial advice. We do not provide recommendations or endorse any decision to buy, sell, or hold any security. We cannot be held responsible [music] for any actions listeners may take and investors are encouraged to seek independent financial advice.