Worst Seen Over as Gilts Escape Back-to-Back Loss: U.K. Credit

The worst is probably over for U.K. government bonds after they avoided the first successive quarterly decline in almost three years, according to money managers overseeing $800 billion in assets.

An end-of-quarter rally helped gilts return 0.5 percent between July and September, data compiled by Bloomberg show. They lost 3.9 percent in the second quarter, the most since 2008, and the selloff continued as investors bet the Bank of England will raise interest rates earlier than Governor Mark Carney has indicated.

“We have been adding to gilt exposure as we think the selloff was excessive,” John Stopford, head of fixed income at Investec Asset Management, which has $103 billion in assets, said in an interview on Sept. 27. “There does seem to be a genuine pickup in growth, but we doubt it will be as strong as some surveys suggested. We are still a long way away from the first rate increase.”

The benchmark 10-year yield will end the year at 2.77 percent, according to the weighted-average estimate in a Bloomberg survey. It was at 2.70 percent today, 90 basis points more than the rate on equivalent German bunds.

With the economy gaining momentum, Carney has struggled to persuade investors that policy makers can keep the benchmark rate at a record-low 0.5 percent for the next three years, as indicated when the bank introduced forward guidance on Aug. 7.

Reinforcing Carney

The 10-year gilt yield has risen 1 percentage point over the past six months and reached 3.05 percent on Sept. 11, the highest since July 2011. The pound is at its strongest versus the dollar in nine months. The extra yield investors demand to hold U.K. instead of German government debt climbed above 100 basis points, or 1 percentage point, on Sept. 18 for the first time since May 2010.

Yields have fallen 30 basis points since then, when the Federal Reserve sent rates on Treasuries tumbling by unexpectedly deciding to refrain from scaling back its $85 billion of monthly bond buying until it sees more signs of a lasting improvement in the U.S. economy.

At the same time, BOE officials from David Miles to Deputy Governor Paul Tucker and Chief Economist Spencer Dale have reinforced Carney in arguing it will take time for unemployment, now at 7.7 percent, to fall to the 7 percent threshold at which policy makers will consider raising borrowing costs. Speaking in London yesterday, Dale said investors betting on a sharp rise in interest rates may need to “think again.”

Surge Over

Short-sterling futures contracts maturing in December 2014 have fallen 19 basis points to 0.81 percent since Sept. 18. Gilts outperformed U.S. Treasuries, German and Canadian bonds in the third quarter, while they lagged behind Japan, France and Italy.

“The surprising economic strength has contributed to the selloff alongside the gyrations in the U.S. Treasury market,” said Willem Sels, head of investment strategy at HSBC Private Bank UK Ltd., which oversees $480 billion in assets. “Gilt yields may grind higher from here, but we think the worst of the yield surge is behind us.”

Gross domestic product in the second quarter was 3.3 percent below its 2008 peak -- only Italy among Group of Seven nations is further behind -- and fragility persists in some parts of the economy. Retail sales fell in August, according to government data, and an industry report yesterday showed manufacturing unexpectedly slowed in September.

‘Gone Beyond’

“We do recognize the improvement in the U.K. economy, which I think have been priced in by both currency and rates, but we believe the move has probably gone beyond what the fundamentals suggest at present,” said Ugo Lancioni, a money manager in London at Neuberger Berman Group, which oversees $214 billion in assets. “Things can always improve further, but at the present we see these levels as relatively attractive.”

Rate setters tasked with meeting a 2 percent inflation target face little risk of an upsurge in consumer prices, based on the latest quarterly survey by JPMorgan Chase & Co. Respondents including money managers, banks and hedge funds see inflation averaging 2 percent over the next 12 months compared with a 2.2 percent estimate in March. Their inflation expectations for the next two to five years dropped to 2.9 percent from 3.1 percent.

“We have felt that the gilt market is too far away from the Bank of England’s forward-guidance message,” said Sam Hill, a fixed-income strategist at Royal Bank of Canada in London. “The market will be wrong to get too carried away by speculation that rates will rise much sooner than the Bank is indicating.”

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