by Yoruk Bahceli and David Milliken
LONDON (Reuters) – British government bonds show their steepest decline since the autumn 2022 “mini-budget” crisis, taking the two-year yield to its highest level since July 2008 – but investors say that there is less reason to panic than last year, this drop could even represent a bargain. The yield on two-year Gilts peaked at just over 4.9% on Wednesday, after topping the previous high of 4.76% reached in September 2022 the day before.
The rapid rise in yields is not without consequence: banks have raised their mortgage rates in recent days, and the Labor Party, in opposition, has said that the rising cost of debt could force it to limit his green investment plans if he comes to power next year.
But if the Gilts market is in the news again, after the turbulence of last autumn which destabilized pension funds, forced the Bank of England (BoE) to intervene and ended up costing Prime Minister Liz Truss her job , investors believe that the current situation is different. Daily trends remain contained, and mainly affect bonds with short maturities, which the context of rising interest rates and uncertainties about inflation had already made more volatile.
Conversely, the movements in September and October were more violent and concentrated on longer-dated securities, where the collapse in valuations took some holders, including pension funds, by surprise. “The vicious cycle linked to pension funds did not start in 2023,” said Jim Leaviss, director of fixed income investments at fund manager M&G.
“This decline in valuations is not that big, and less related to fiscal stability issues than to the interest rate and inflation environment,” he added. Tuesday’s release of payroll data sparked sales in Gilts, with short-term stocks posting their biggest one-day drop since October.
This data added to a series of other indicators which show that inflationary pressures remain persistent in the United Kingdom, despite weak economic growth, which prompted markets to revise their BoE rate expectations upwards. .
Markets now believe BoE rates may hit 6% early next year, up from 4.5% to 5.5% before Tuesday’s data release, sending the price of Gilts down to short term sensitive to expected interest rates for the BoE. BoE Governor Andrew Bailey, speaking before a parliamentary committee on Tuesday, acknowledged that the fall in inflation had been slower than expected by the central bank and that the latest labor market data was “very solid”.
UK consumer price inflation was 8.7% in April, the highest rate among major advanced economies tied with Italy, and the BoE does not expect to see inflation fall back to 2% before the start of 2025.
ARE GILTS CHEAP? For some investors, Gilts are increasingly attractive, because a key rate of 6% seems unrealistic. “We were negative on Gilts compared to other markets for the last 18 months (…) but their decline is starting to seem exaggerated, and we have revised our positioning upwards this week”, explains Mike Riddell, manager of bond portfolio at Allianz Global Investors. The yield on two-year Gilts has risen 110 basis points (bps) this year, compared to a rise of 30 bps for the German two-year yield and 20 bps for the US Treasury rate of the same maturity. Raising interest rates to 6% would “destroy demand” across the economy, Mike Ridell said. With markets pricing UK inflation at around 3% over the medium term, Mike Riddell explains that part of that figure represents the cost of inflation protection, suggesting markets are betting inflation around 2, 5%. “Compared to other markets, valuations suggest the Gilts market is in trouble, but there are no tangible issues this time around,” added Mike Riddell.
PIMCO, one of the world’s largest asset managers, also said on Monday that Gilts may have value and said it was overweight the asset in some funds.
The 10-year Gilt yield now offers an interest rate nearly two percentage points higher than the equivalent German government bond, the largest premium since 1997 excluding the turmoil in the global economy. last fall. Even though inflation is easing faster than markets expect, the bond market continues to face headwinds. Prospects for interest rate hikes explain only half of Gilts’ underperformance relative to US and Eurozone sovereigns, with the rest of the underperformance due to other factors , such as larger debt issuances, according to Moyeen Islam, bond strategist at Barclays.
Gross UK government issues are down from pandemic records, but remain sizeable as they are expected to reach 238 billion pounds (277.51 billion euros) for the current fiscal year.
At the same time, the BoE has become a seller of Gilts: it sells about 10 billion pounds of securities each quarter and does not reinvest the proceeds of a similar volume of Gilts maturing each quarter.
“The markets are starting to price in the glut of supply which, added to the rise in yields, is putting the markets under pressure”, summarizes Moyeen Islam.
(Report Naomi Rovnick, Dhara Ranasinghe; editorial David Milliken; French version Corentin Chapron, edited by Blandine Hénault)
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