BOE Inflation Threat Means Linker Returns Top Italy: U.K. Credit

As Mark Carney prepares to take charge of the Bank of England, U.K. inflation expectations are close to a two-year high with policy makers focusing on growth even if it means letting consumer-price gains accelerate.

British bonds with returns tied to the rate of inflation have gained the most among 18 nations that sell so-called linkers, according to Bank of America Merrill Lynch data. The U.K. breakeven rate, or the difference between yields on indexed and non-linked debt, rose to 3.27 percentage points from 2.67 points at the start of the year. Relative to the U.S., inflation expectations are near the highest level since January 2012 and the returns were even higher than on Italy’s securities.

Bank of England officials said last month that inflation will quicken from the current 2.7 percent and remain above the 2 percent target until early 2016. Policy makers said they will concentrate on measures to keep the country from falling into a new recession and Carney, who succeeds Governor Mervyn King on July 1, has indicated he favors a more flexible approach to controlling price growth.

“The change of leadership with the arrival of Carney at the bank will bring someone who has been quite outspoken and open to new measures,” Dagmar Dvorak, a director of fixed-income and currencies in London at Baring Asset Management, which oversees $50 billion, said in a telephone interview on March 4. “It would also bring a prolonged period of higher inflation,” said Dvorak, who has been buying more linkers.

Inflation Bonds

U.K. inflation-protected bonds have returned 3.1 percent this year, the most among countries tracked by Bank of America Merrill Lynch’s bond indexes. Turkey and Mexico are next, at 2.6 percent in the period. Italian linkers earned 1.2 percent, after a more than 27 percent return in 2012. British inflation has averaged 2.8 percent in the 13 months through January, compared with 3.2 percent in Italy, according to government figures.

Gilts that aren’t tied to changes in consumer prices are the world’s worst performers on a currency-adjusted basis, losing 1.4 percent this year in pound terms, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. By contrast, U.S. Treasuries earned more than 7 percent in the period on the same basis.

Recession Risk

Inflation has remained above 2 percent for more than three years, partly because the weaker pound has driven up import prices. Sterling slumped 6 percent this year, the largest drop after the yen among 10 developed-market currencies tracked by Bloomberg Correlation-Weighted Indexes.

The pound was little changed from March 8 against the dollar at $1.4922 at 9:42 a.m. in London. The yield on the 10-year gilt fell 3 basis points to 2.029 percent.

Gross domestic product fell 0.3 percent in the fourth quarter, and the economy is 3 percent smaller than in early 2008. A contraction in the current quarter would mark an unprecedented third recession in the U.K. since then.

Britain hasn’t emerged from the worst financial crisis since the Great Depression as the euro-area debt crisis saps demand for exports, inflation outpaces wage increases and government spending cuts bite. Chancellor of the Exchequer George Osborne made the steepest public spending reductions since World War II to protect the nation’s top credit rating and preserve the confidence of the bond market.

Instead, Moody’s Investors Service stripped the U.K. of its Aaa rating on Feb. 22, while 375 billion pounds ($560 billion) of gilt purchases with new money by the Bank of England have fed concern that inflation will accelerate. Italy was cut one level to BBB+ with a negative outlook by Fitch Ratings on March 8.

Default Swaps

U.K. credit-default swaps climbed 18 percent this year as of March 8 as investor sentiment deteriorated, according to data compiled by Bloomberg. That’s more than for any other developed nation, with only Argentina and Egypt swaps prices rising more.

Three of the nine members of the Bank of England’s Monetary Policy Committee, including King, voted last month to expand a bond-buying program known as quantitative easing to pump more money into the financial system and bolster the economy. Deputy Governor Paul Tucker told lawmakers on Feb. 26 that it may be possible to spur banks to lend by charging them to keep deposits at the central bank.

A “prolonged” period of above-target inflation may be the trade-off required to avoid “undesirable volatility in output in the short run,” King, 64, told a news conference on Feb. 13 after the central bank published its quarterly economic outlook.

Carney ‘Tolerant’

Carney, 47, the current Bank of Canada governor, has indicated his preference for flexible inflation targeting. He told British lawmakers Feb. 7 that central banks “can vary the horizon” for meeting inflation goals if economic stability is at risk. U.K. linkers are little changed since his testimony.

“Carney’s comments so far have been fairly tolerant of higher inflation,” Peter Dixon, an economist at Commerzbank AG in London, said in a telephone interview on Feb. 27. “We’re probably heading for an environment where market expectations or inflation will be edging up a bit.”

The spread between U.K. and U.S. 10-year breakeven rates increased to 69 basis points, or 0.69 percentage point, on March 8, from minus 11 basis points in October. The U.S. breakeven rate was 2.58 percentage points last week.

The Bank of England’s emphasis on growth mirrors central bank policies in the U.S. and Japan.

The Federal Reserve said in December that it will keep interest rates low at least as long as unemployment remains above 6.5 percent and inflation is projected to be no more than 2.5 percent. The jobless rate fell in February to 7.7 percent, the lowest level since December 2008, and employment rose by 236,000, Labor Department figures showed March 8 in Washington.

Fighting Deflation

Policy makers said at their Jan. 29-30 meeting that they will continue $85 billion in monthly bond purchases until the labor market improves “substantially.”

In Japan, the central bank is seeking to end 15 years of deflation with a 2 percent inflation target and unlimited asset purchases starting next year. Bond yields are near decade lows as investors expect the Bank of Japan to take more aggressive steps once Governor Masaaki Shirakawa steps down on March 19. Asian Development Bank President Haruhiko Kuroda, a proponent of more stimulus, has been nominated to replace him. Japan’s five-year breakeven rate reached 1.42 percentage points last week, with the yield on the non-indexed-linked note at 0.105 percent.

U.K. linkers also got a boost this year, after their worst performance in about a decade in 2012, as the government said on Jan. 10 that it decided against changing how it calculates the retail price index, which determines prices of linkers.

Monetary Stimulus

Non index-linked gilts fell the most since Feb. 13, erasing this month’s gains, after the Bank of England refrained from expanding its quantitative-easing program on March 7. Ten of 39 economists in a Bloomberg News survey had predicted an expansion of at least 25 billion pounds. The rest forecast no change. The bonds have lost 0.3 percent this month, compared with a loss of 0.8 percent for Treasuries, according to Effas indexes.

King and Paul Fisher joined David Miles in February in calling for additional monetary stimulus. Tucker told lawmakers he remained open to doing the same, and discussed introducing negative interest rates, or charging banks instead of paying them to hold their cash at the Bank of England.

“The U.K. has had a very severe recession, but we’ve had a pretty poor performance on the inflation front,” Mark Capleton, a fixed-income strategist at Bank of America Corp. in London, said in a phone interview on March 4. “All these pressures make U.K. linkers look like one of the more attractive markets on a breakeven basis.”

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