Markets

Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

That sterling flash crash might be the least of Theresa May's problems. There's a potential gilt crisis brewing, and if her honeymoon was fizzling out now, that would make it well and truly over.

Foreign investors are turning away from U.K. government bonds, and it might get worse. Even though the Bank of England's quantitative easing promises continued buying, the Treasury isn't the only source of supply these days.

Not So Hot
Gilts have underperformed as sterling assets fall out favor.
Source: Bloomberg

Their counterparts around the world are contending with the International Monetary Fund's decision to let the yuan count as a global reserves currency. This change was decided last year and came into effect on October 1, and it matters for global central banks, who've positioned the vast majority of their sterling holdings in gilts.

They're now looking at a 10.9 percent weighting for the Chinese yuan in the IMF's Special Drawing Rights basket, and a cut in the U.K.'s weighting to 8.1 percent from 11.3 percent. That's a recipe for selling gilts.

True, the U.K. domestic market may happily soak up any ultra-long bonds that surface, as pension funds and life insurers face a seemingly endless scramble to match their long-term liabilities. But the shorter part of the curve should continue to underperform relative to its peers.

Twice the Fun
Gilt yields have nearly doubled as inflation worries sink in
Source: Bloomberg

And then there's the inflation monster, which we all know is coming. The rout in sterling is already set to push up prices of imported goods, especially food and fuel. Any feed-through from the recent pickup in oil prices will worsen the situation.

The publication next week of the September inflation reading is a potential speedbump for the outlook for prices -- Bloomberg Intelligence's Dan Hanson says it could pickup to as much as 0.8 percent from 0.6 percent in August. A big factor will be fuel prices, which have risen by more than 1 percent this year, after dropping almost 3 percent between August and September last year.

Hello, Inflation
The Bank of England sees CPI heading above its 2 percent target by around the end of 2017.
Source: Bank of England August 2016 Inflation Report

Someone has already spotted that -- just look at the big spike in a measure of expected future inflation called the "5-year forward 5-year inflation breakeven rate."

Big Spike
This proxy for future inflation expectations shows price gains are coming
Source: Bloomberg

While a consumer price index surge might be temporary, sometimes it is just better to be safe than sorry. Investors appreciate this, and that could push gilts from being somewhat less popular to full-blown pariah.

The last thing Prime Minister needs is a bond selloff. Triggering Article 50 in March will be so much harder if the financial markets are misbehaving.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Marcus Ashworth in London at mashworth4@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net