Nov. 10 (Bloomberg) -- U.K. index-linked gilts may outperform conventional bonds amid concern the Bank of England’s reluctance to boost interest rates will allow inflation to accelerate, Merrill Lynch Wealth Management said.

Shorter-dated notes may fall in value in the first half of 2010, narrowing the spread with longer maturity bonds and causing a so-called bear flattening, as rising prices eventually prompt policy makers to exit stimulus measures, according to Bill O’Neill, who helps oversee $1.9 trillion. There’s a risk that investors might judge that policy makers have been too “aggressive” in tackling the recession, he said.

The Bank of England last week increased bond purchases by 25 billion pounds ($41 billion) and left the key interest rate at a record low of 0.5 percent to help end the longest recession on record. Policy makers predicted “a slow recovery in the level of economic activity.”

“The theme for next year will be very much a bear flattening in the curve as the tightening cycle begins,” said O’Neill, a portfolio strategist at Merrill Lynch in London. “In those circumstances index-linked bonds will outperform against the fixed-income benchmark. Indeed, we think it’s very difficult at the moment to make a case for conventional bonds.”

The difference in yield, or spread, between two- and 10- year gilts narrowed to 304 basis points as of 3:15 p.m. in London, from 307 basis points yesterday, the most since at least 1992, according to Bloomberg generic prices.

Inflation Rate

The U.K.’s annual inflation rate was at 1.1 percent in September, while consumer prices declined in the euro area and in the U.S. The U.K.’s 10-year breakeven rate, a gauge of market inflation expectations derived from a yield gap between regular and index-linked bonds, was at 2.77 percentage points, compared with 2.23 percentage points in the U.S. and 1.88 percentage points in Germany.

Investors’ inflation expectations stayed higher even as the U.K. lagged behind other major economies in recovering from the slump. The U.S. emerged from its recession in the third quarter while Germany and France, the two largest euro-area economies, returned to growth in the second. The U.K. economy shrank 0.4 percent in the third quarter, the Office for National Statistics reported on Oct. 23.

Recovery Chance

Other reports show some improvement in the economy. Manufacturing unexpectedly expanded in October at the fastest pace in two years, a gauge based on a survey of companies by the Chartered Institute of Purchasing and Supply and Markit showed Nov. 2. A gauge of U.K. house prices rose to the highest level in almost three years, the Royal Institution of Chartered Surveyors said in its monthly survey today.

“There’s a chance that the U.K. will actually show a strong performance and that the more medium term reaction will be a stronger adjustment in yields across the curve once the rate-tightening cycle starts,” O’Neill said. The stimulus measures undertaken by the central bank may next year be “seen as too aggressive, probably a step too far. But right now they feel they have to take that chance,” he said.

The Merrill Lynch unit is a division of Charlotte, North Carolina-based Bank of America Corp.

To contact the reporters on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net;

Last Updated: November 10, 2009 10:46 EST