Incredibly Expensive

An Exercise in Ignoring the Rate-Hike Train Coming at You

Gilt investors are purely focused on short-term supply and demand.
Christophe Morin/Bloomberg

We knew it was coming, and here it is. U.K. inflation is finally cooling. 

Normally a 0.3 percentage point drop in the rate would kill expectations for higher interest rates. But government bonds are living in a dream world. Though the Bank of England seems determined to look through the slowdown in consumer prices,  gilts haven't got the message -- they're incredibly expensive.

Reality Check

The recent drop in U.K. yields shows investors are purely focused on short-term supply and demand

Source: Bloomberg

The central bank wants to get itself on a rate hiking cycle in earnest. And that could be as soon as May 10, depending on how hawkish the minutes are from Thursday's monetary policy meeting. A host of market measures are pointing to that date, and chief among these are June 2018 short-sterling interest rate futures, which have priced in an 80 percent expectation for the bank's key rate to rise 25 basis points to 0.75 percent.

Officials are really concerned about projections for inflation to hold above their 2 percent target, and for wage growth to accelerate -- and this makes Wednesday's labor market data even more important to watch than usual. Policy makers will look through the fact that the inflationary effects of weaker sterling after the Brexit referendum are dropping out of calculations. 

So it's all going swimmingly for Mark Carney. Monday's news of a breakthrough Brexit transition deal looks as smooth as the governor himself. This creates a green light for the Monetary Policy Committee to push ahead with a drive to withdraw stimulus regardless of the potential turmoil surrounding Britain's withdrawal from the European Union.

But as the risks diminish that Brexit will be a tough ride for Britain, so does the safety appeal of government bonds. 

Gilts are the most expensive major bond market in the world on an inflation-adjusted basis. Even with Tuesday's report that inflation dipped to 2.7 percent in February, that still leaves the real return for 10-year yields at minus 1.3 percent. The gap between 10-year U.S Treasuries and gilts has now widened to record 140 basis points. This might be partially justified if the Fed were the only central bank raising rates. But given that the BOE is doing all it can to gatecrash this party, U.K. fixed income markets need a reality check.

Widening Pond

It doesn't make sense for U.S. government bond yields to be at a record premium to the U.K. since both central banks are tightening policy

Source: Bloomberg

To be fair, the government's fiscal position has improved. Chancellor of the Exchequer Philip Hammond last week pared issuance plans for the next financial year, and that relative scarcity of issuance will lend some support to the market. But really it may be a case of keeping yields from screaming higher. 

There's also a massive buyer keeping a lid on yields -- the BOE is part-way through replenishing its QE stocks of gilts. But by mid-April it will have finished buying back 18.3 billion pounds across the yield curve. Once that behemoth leaves the room then rate hike reality will soon dawn on gilts -- but better to face the facts sooner rather than later. Or even, now.

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

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