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Remaining Bearish on Gilt Yields

19 September 2017 by Mark Holman

The last week has given us plenty to consider in terms of our view on UK rates and the Gilt curve.

If the EU membership referendum had resulted in a vote to stay then we most likely would be following the US into a pattern of gradual rate hikes, and while we may not have had four of them by now we certainly would not have had the emergency rate cut imposed in the summer of 2016. Obviously things turned out differently and it seems that investors have become entrenched in the view that while the UK tries to negotiate the challenging road out of EU membership there can be no rate hike and Gilt yields can remain nailed to the floor.

The last few days has seen the realisation that this is not true and we are quite likely to face our first rate hike in the coming months. The strongest evidence came from Mark Carney himself at yesterday’s IMF speech where he focused attention on the impact of globalisation on inflation. He mentioned that for years this has had a deflationary effect on wages and the price of goods. In turn these profound forces in the global economy have pushed down the average level of world interest rates by 450bps over the past 30 years. However, Mr Carney went on to say that “Brexit, relative to the experience of the last half a century, is unique. It will be, at least for a period of time, an example of de-globalisation not globalisation for the UK and it will proceed rapidly and not slowly”. Carney went on to say therefore “if globalisation is disinflationary then won’t Brexit be inflationary?” intimating that there is a reduction in the MPC’s tolerance for above-target inflation, and that some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target.

The move in Gilt nominal and real yields has been sharp and in part reflects this entrenched view. Over the past week the 10 year yield has risen around 30bps, which in price terms is close to 3.5 points, or the equivalent of 3 years’ worth of income.  In the Index-Linked market, the long dated 2068 issue has fallen in price by 36 points!

We had been bearish on Gilt yields and expected some yield curve steepening due to inflationary pressures, some of which we felt could be persistent rather than transitory. Our 12 month forecast for 10 year Gilts was for them to move to 1.25%, a level which has now been exceeded, and justifiably so, as we now need to factor in at least one rate hike into this view. Conservatively, even taking our forecast to 1.50% means further losses are still on the horizon for Gilt investors. From today’s level at 1.29% our view would imply almost another 0.5% of negative total return over the 12 month forecast period.

Consequently we remain of the view that despite the benefit of Gilts’ negative correlation to broader credit markets, the price paid for this is currently still too high and investors should proceed with caution or try to time their entry with this in mind.



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