Prospect of more gilts sales challenges UK bond market

Posted on November 24, 2016

If there are political similarities in the impulses which led the UK to vote for an exit from the EU and the US for Donald Trump, the market reaction to Wednesday’s collection of new British tax and spending measures served to illustrate economic differences between the two countries.

While Trumponomics has fast become shorthand for a promised programme of tax cuts and infrastructure incentives which could rival the actions of Ronald Reagan, there are no neologisms yet to describe the fiscal programme of the Conservative government revealed by the chancellor’s Autumn Statement.

“It’s not Reaganomics we’ve seen from Philip Hammond, it’s just a response to expectations of an economic slowdown following Brexit,” says Jim Leaviss, head of fixed income at M&G Investments.

He points to the movements in short term bond yields to underline the point. In the US, two-year Treasury yields have jumped from 0.78 per cent to 1.13 per cent since the election, the highest level since early 2010, as traders finally anticipate multiple increases in interest rates set by the Federal Reserve as the US economic recovery gathers pace.

In the UK, by comparison, two-year yields were 0.17 per cent on Wednesday, tumbling in the past month to leave them barely changed from the day after the EU referendum.

The challenge for gilt investors may be to disentangle the market from that of others, such as the US. Growth of the UK economy is expected to slow next year, when negotiations over the terms of exit from the EU are expected to begin.

Yet at the same time the collapse in the value of the pound is likely to contribute to higher import prices. Prices for securities linked to inflation imply an average UK rate of more than 3 per cent during the next five years, versus less than two per cent for the US and less than 1 per cent in Europe.

Inflation eats away at fixed income securities, and the context for the gilt market is a reversal of the rally in global government bonds which drove the UK’s 10-year borrowing rate to a historic low of just 0.5 per cent in August.

Longer dated bonds did react to Mr Hammond’s announcement that the UK must borrow more in coming months to combat a slowing economy, as investors speculate on the market’s ability to absorb billions of pounds of new debt at a relatively quiet time of year.

Of the additional £20.6bn the government needs to raise between now and April 2017, £15bn will be funded via gilt sales.

As the coupon on sovereign debt is fixed at the time of issue, it falls in value as market yields rise. On Wednesday the yield on benchmark gilts jumped 11 basis points, to 1.47 per cent.

“The increase in gilt issuance came as a surprise to all of us,” says Thomas Sartain, a fixed income fund manager at Schroders.

“Gilts have been trading very poorly since the summer and there are some concerns the market will struggle with a 10 per cent jump in total issuance. We’re not approaching a crisis, but the market is signalling that it is aware that the country’s borrowing needs have changed significantly,” he says.

Mike Amey, a portfolio manager for the bond specialist Pimco, says the reaction also reflected a shift in the approach to deficit spending, with previous deadlines and targets abandoned: “Getting the budget to balance is not something at the forefront of the government’s agenda”.

However, like others he says not to overplay the movement in a market where yields remain low and the Bank of England continues to buy government debt.

Bond yields were also rising across Europe and in the US on Wednesday, in markets dominated by debate about the extent of improvements in the US economy likely under a Trump administration.

Until now, gilts have been cushioned from larger moves by persistent demand from domestic pension funds with payment promises to keep, in addition to central bank purchases of gilts every week as part of a new quantitative easing programme to support the economy following the vote for Brexit.

“That dynamic hasn’t changed,” says Luke Hickmore, investment director at Aberdeen Asset Management. “But investors are having to get their heads around a huge shift in the country’s balance sheet. Those extra debt requirements combined with the US reflation trade is going to increase the cost of borrowing at a tricky time for the UK government.”

The problem for the UK may come if US politics continues to influence bond prices around the world at the expense of domestic efforts to keep borrowing costs down.

“The market is placing a huge reliance on price insensitive investors such as [pension and insurance fund] managers to close their eyes and buy,” says Craig Inches, head of short rates at Royal London. “But I fear even they may be a little less hasty in an environment where yields are rising.”

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