Gilts ride Brexit roller-coaster

Gilt yields have been highly volatile during the past year owing to a number of factors, including uncertainty around the Brexit process, inflationary expectations, the pick-up in the global economy and changes in interest rates in the UK and the United States.

Over the past few months, the yield on the 10-year Gilt rose from 1.14% in mid-December to 1.65% on February 15, subsequently embarking on a downward trajectory it has been on virtually ever since (1.36% towards the end of March).

The main reason for the initial rise was the perception that the Bank of England would raise interest rates this year to rein in inflationary pressures that have built up since the sharp devaluation of sterling following the EU referendum on June 23 2016. The bank is more confident about putting rates up now because of the improved global economic backdrop.

The World Bank forecasts global economic growth to edge up to 3.1% this year, as the recovery in investment, manufacturing and trade continues. Growth in advanced economies is expected to be slower, at 2.2%, as central banks gradually remove the economic stimuli that have been applied since the global financial crisis.

On November 2, the Bank of England’s Monetary Policy Committee voted to raise the base rate by 25bp to 0.5% – the first rise since 2007. At its meeting on March 22, the MPC was divided about raising rates further at that time, with most analysts having expected a unanimous decision not to. Expectations are now for a further 25bp increase in May.

“No central bank would want to keep interest rates as low as they are currently,” said David Owen, chief European financial economist at Jefferies. “Low interest rates have already had a big impact on the UK’s residential property market and they affect people’s behaviour in many ways.”

UK workers’ overall pay rose at the fastest pace in more than two years during the three months to January, also increasing the likelihood that the Bank of England would raise rates in May.

Mitul Patel, the head of interest rates at Janus Henderson Investors, said: “The Bank of England decided to give the economy a stimulus through quantitative easing immediately after the Brexit vote. But the economy has not weakened as much as it was expecting and the employment rate has now come down.

“The Bank of England can now be a bit more hawkish about interest rates and take back the stimulus it provided. The Brexit process does create a lot of uncertainty and economists are focused on labour market dynamics to gauge how strong the economy is.”

Two-way pull

Gilts are being pulled in two directions: by expectations that interest rates are about to rise but also by concerns around the uncertainty of the Brexit process.

The Bank of England believes that Brexit creates greater economic uncertainty and will lead to lower long-term economic growth. Despite the drop in inflation, it needs to put up rates to ensure that wage pressures do not build up and that the economy does not run the risk of over-heating.

However, investors also regard Gilts as something of a safe haven. This was seen starkly following the Brexit vote, when they turned to them as a last resort and the 10-year yield troughed at a historic low of 0.51% on August 12 2016.

More visibility now exists around the Brexit process, as the UK and the European Union have made a provisional agreement on the terms of a 21-month transition period, ending on December 31 2020. This makes a Bank of England rate rise in May more likely, as it can now focus on reining in inflationary pressures. The markets are now pricing in an almost 85% probability of that happening.

However, there is still great uncertainty regarding the border between Northern Ireland and the Irish Republic and around the final shape of the trade deal between the UK and the EU. Investors could again turn to Gilts as a safe haven if the relationship between the UK and the EU deteriorates in a big way. Many feel the most challenging part of the Brexit process is still to come.

“Gilt yields are affected by an interplay between the Bank of England’s behaviour and the Brexit negotiations,” said Andy Chaytor, UK rates strategist at Nomura. “We have seen consistent market pessimism about the end state of the UK following the Brexit process and about the state of the economy in the long term.

“The negative expectations come from international investors in Gilts as well. With this backdrop, any surprises around the Brexit process are likely to be positive ones. Gilts are seen as a safe haven, but if there is good news there will be less reason to hold Gilts for this purpose, pushing up yields.”

The pick-up in the global economy prompted the US Fed Reserve to raise its funds rate again to a range of 1.50%–1.75% on March 21, impacting Treasury and Gilt yields. Officials have raised their median estimates for US economic growth to 2.7% this year and to 2.4% next year. The Fed argued that the US jobs market was strong and signalled it may accelerate the pace of rate increases. This was the sixth rise since 2015 and the markets expect several more this year.

The rise had an impact on Treasuries, with the 10-year yield jumping to 2.85% on March 26 from around 2.35%–2.40% in November and December.

Most analysts think the ECB remains some way off raising interest rates given subdued inflation in the bloc. The 10-year Bund yield rose to 0.54% on March 26 from 0.40% at the start of the year.

The upward shift in sovereign bond yield curves is being driven largely by investors’ expectations that the strengthening global economy will lead central banks to unwind QE and put up rates more quickly than previously thought.

The slight reduction in the supply of Gilts coming onto the market this year is not expected to have much impact on yields. In his spring statement at the end of March, Philip Hammond, the Chancellor of the Exchequer, announced the lowest net public borrowing needs since 2002 and indicated that UK government bond sales during the coming financial year will be the lowest since the financial crisis.

Gross Gilt issuance will be £102.9bn for the 2018 to 2019 financial year against £115.1bn during the past year. Issuance of around £25.7bn per quarter will not be sufficiently lower than £28.8bn for the past year to push yields lower. The planned mix of issuance is being tilted slightly towards short and medium-dated Gilts; long-dated bonds will account for 28.5% of the total.

“This is a welcome drop in issuance,” said Jason Simpson, interest rates strategist at Societe Generale. “But there will still be a fair amount of issuance coming onto the market. In fact, the markets were expecting a bit less.”

The Bank of England has kept a lid on yields through replenishing its QE stock of Gilts but this will come to an end very soon. By mid-April, it will have finished buying back £18.3bn across the yield curve.

Knock-on effect

Gilt yields are also expected to rise at the end of the year as the ECB ends its QE programme. The central bank has been buying government bonds from eurozone financial institutions, the proceeds from which they then on-lend on to businesses and invest where they deem appropriate. It has left eurozone banks with a glut of cash they have also invested externally – in part in Gilts and Treasuries.

“The Gilt market will lose this support from foreign buying,” said Jefferies’ Owen. “Lower demand will lead to lower bond prices, so Gilt yields will rise.”

There is always a contrary argument, however. At the end of March, the spread between 10-year Gilts and 10-year Bunds was close to 90bp, but many strategists – including at UBS and HSBC – expect it to narrow to 40bp–50bp by the end of the year. Their analysts expect uncertainty around Brexit to be the deciding factor, increasing demand for Gilts as a safe haven. This would push bond prices up and yields down.

“Even if you get a short-term rise in yields in the front end in response to a transitional deal, that will run out of steam later in the year as it becomes evident that the problems that lie ahead are much greater than the ones that have been negotiated,” said John Wraith, head of UK rates strategy at UBS.

Gilts will remain sensitive to any news about Brexit until the most intractable issues around the Irish border and the future trading relationship between the UK and the EU have been resolved.

In normal circumstances, analysts would feel confident that a rise in interest rates in Britain this year would lead to an increase in Gilt yields, but the important role Gilts are playing as a safe haven in the midst of the uncertainty surrounding Brexit is having the opposite effect.