U.K. Bonds Decline as Morgan Stanley Brings Forward BOE Forecast

U.K. government bonds fell for the first time in three days as Morgan Stanley joined banks predicting the Bank of England will increase interest rates in the first quarter of next year, dimming demand for gilts.

The extra yield investors demand to hold 10-year U.K. securities instead of similar-maturity German bunds expanded to a euro-era record. As Britain’s economic expansion surpasses forecasts, including those of the International Monetary Fund, more than half the 29 financial institutions surveyed by Bloomberg now see an increase in central bank rates by March.

“Our economists have moved forward the timing of the first rate hike,” Anthony O’Brien, a fixed-income strategist at Morgan Stanley in London, wrote in a note today. “As a result, we have raised our two-year gilt yield forecasts. The continued bright outlook for the U.K. economy, in contrast to the much more tepid/fragile recovery in the euro zone, should mean that gilts continue to underperform bunds.” Morgan Stanley is one of 21 primary-dealer banks that trade with the Debt Management Office directly.

U.K. two-year yields climbed four basis points, or 0.04 percentage point, to 0.71 percent at 4:12 p.m. London time. The 2 percent gilt due in January 2016 fell 0.065, or 65 pence per 1,000-pound ($1,679) face amount to 102.065.

Morgan Stanley’s base-case forecast is for the two-year yield to rise to 1.2 percent by the end of this year, from 1 percent previously. The central bank will raise rates three times in 2015, London-based economists Melanie Baker and Jonathan Ashworth wrote in a note published today. They’d previously said the first increase would come in the second quarter of next year.

Spreads Widen

The U.K.’s 10-year rate rose five basis points to 2.70 percent, leaving the extra yield that investors get for holding the U.K. securities instead of German bonds at 132 basis points, the widest since before the euro’s introduction in 1999, based on closing prices. The spread over French securities was 99 basis points, the most since October 2005.

A growing U.K. economy has spurred bets the BOE will hasten plans to raise rates, while the threat of deflation in the euro area prompted the ECB to expand stimulus. The IMF underestimated the strength of the U.K. economy when warning against the government’s austerity program, Managing Director Christine Lagarde said in an interview broadcast yesterday.

“We got it wrong,” Lagarde told the “Andrew Marr Show” on BBC Television. “Clearly the confidence building that has resulted from the economic policies adopted by the government has surprised many of us.”

Forward Rates

The nine members of the Bank of England’s Monetary Policy Committee in London left the benchmark interest rate at 0.5 percent last week, while maintaining asset purchases under their quantitative-easing program at 375 billion pounds. In contrast, the ECB in Frankfurt introduced an unprecedented package of stimulus measures, including lowering its deposit rate below zero for the first time.

Investors are betting the Bank of England’s benchmark rate will rise 25 basis points by next May, according to forward contracts based on the sterling overnight interbank average, or Sonia. They show the rate reaching 1 percent in August 2015.

Buoyed by the stronger economy, sterling has jumped 8.1 percent in the past 12 months, the best performer among 10 developed-nation currencies tracked by Bloomberg Correlation-Weighted Indexes. The euro gained 2.5 percent, while the dollar slipped 0.6 percent.

The pound was little changed at $1.6789 today and strengthened 0.3 percent to 80.96 pence per euro.

“In the U.K., economic data remains supportive,” Peter Rosenstreich, chief currency strategist at Swissquote Bank SA in Geneva, said in an June 6 interview. “It’s true that the first rate hike is a while away, but conditions suggest a clear path toward tightening.”

Investors should buy the pound against the Canadian dollar, Rosenstreich said, with prices likely to push toward C$1.90. The pound traded at C$1.8312 today.

Gilts returned 3.3 percent this year through June 6, according to Bloomberg World Bond Indexes. Treasuries earned 2.8 percent and German securities gained 4.1 percent.