Markets

Mark Gilbert is a Bloomberg Gadfly columnist covering asset management. He previously was a Bloomberg View columnist, and prior to that the London bureau chief for Bloomberg News. He is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”

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.

Grab a handful of accelerating inflation. Mix in deadlocked negotiations with your biggest trading partner, and a central bank poised to tighten policy for the first time in almost a decade. Add a large pinch of domestic political risk, and heat over the fire of a potential budget giveaway next month. It's a recipe for sustained underperformance in U.K. government bonds.

Investors have been shunning gilts in recent weeks, driving the gilt futures contract to its lowest price since February. On a three-month basis, gilts have delivered a return of just 0.05 percent, compared with the 2 percent available on Italian debt, more than 1.5 percent on French government bonds and 1.2 percent from German bunds. 

Dropping to an Eight-Month Low
Gilt futures contract
Source: Bloomberg

Figures scheduled for Tuesday are expected to show consumer prices accelerated by 3 percent last month, their fastest increase in more than five years.

That same day sees Bank of England Governor Mark Carney appearing before Parliament's Treasury Select Committee, where he faces a grilling on the bank's failure to meet its 2 percent inflation target. Price gains are destroying the return on 10-year gilts.

Several Months of Underperformance
Benchmark 10-year bond yields adjusted for inflation
Source: Bloomberg

The central bank's response, outlined in the minutes of its Sept. 14 meeting, is to threaten that "some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target."

While the Federal Reserve and the European Central Bank have carefully guided the market to anticipate taking their collective feet off the accelerator, the Bank of England message caught traders and investors by surprise. The likelihood of a rate increase in November jumped above 50 percent in response, and has continued to rise ever since.

Changed Expectations
Likelihood of a Bank of England rate increase on Nov. 2
Source: Bloomberg's WIRP function

Chancellor Philip Hammond is under increasing pressure to loosen the purse strings at his forthcoming budget on Nov. 22. While resisting making specific provisions in the event of no deal on Brexit, he has put 500 million pounds ($665 million) aside for contingency planning, and said that more will be allocated in the budget for 2018. 

Hammond may need to contrive a "shock and awe" budget to correct the government's trailing position in the polls to a resurgent Labour Party. For its part, Labour's threat to take government ownership of rail, water and energy companies would mean more gilt sales to pay for those purchases. In short, the U.K. domestic political scene is far from stable.

All of which leaves the pound, which has gained almost 8 percent against the dollar this year, looking vulnerable. In the past month, it's been the second-worst performing major currency against the greenback, beaten only by the Canadian dollar.

Losing Ground
One month performance versus U.S. dollar
Source: Bloomberg

Sterling has been particularly sensitive to every twist and turn of the Brexit developments. And the U.K.'s future relationship with its biggest trading partner remains shrouded in doubt.

Prime Minister Theresa May will dine Monday with European Commission President Jean-Claude Juncker and chief Brexit negotiator Michel Barnier; the latter last week described talks over the U.K.'s bill for departing the European Union as reaching "a state of deadlock."

If May fails to persuade leaders of the bloc that the separation talks are sufficiently advanced for negotiations about the future relationship to begin, the risk of Britain leaving the EU without an agreement will increase. At which point, the U.K. economy, its bond market and its currency will have the final say on whether no deal really is better than a bad deal.

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

To contact the authors of this story:
Mark Gilbert in London at magilbert@bloomberg.net
Marcus Ashworth in London at mashworth4@bloomberg.net

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