BOE Seen Holding Rates Through 2015 in Boosts for Gilts

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Investors who missed out on the best year for U.K. government bonds since 2011 by betting the Bank of England would raise interest rates risk repeating the mistake.

That’s the view of Kames Capital Chief Investment Officer Stephen Jones, who says gilt yields have further to fall as U.K. growth slows and the euro area struggles to gain momentum.

It’s an opinion at odds with some analysts. According to the median forecast in a survey compiled by Bloomberg, 10-year yields will rise by more than a percentage point to 3.2 percent by December 2015. For Jones, history may be a better guide. A year ago, the yield was forecast to gain about half a point by the end of 2014. Instead, it has dropped almost 1 percentage point, with money markets now all but ruling out a rate increase next year.

“The outright direction and return available from gilt markets has surprised even us,” said Edinburgh-based Jones, whose company, a unit of Dutch insurer Aegon NV, manages about 53 billion pounds ($83 billion). “With some of the increased weakness in Europe right now, and them being our largest trading partner, I don’t think the bank will get around to raising interest rates next year.”

U.K. bonds will also be supported by 10-year yields that are still 1.2 percentage points above those in Germany and amid pension-fund demand for longer-dated debt, said Jones.

Inflation Slowdown

While gilt bears are encouraged by an economy set to outpace its Group of Seven counterparts this year, an inflation rate close to its lowest level since 2009 risks being further depressed by tumbling oil prices, giving the BOE scope to keep interest rates at a record-low 0.5 percent. Government spending cuts stretching as far as 2020 may also weigh on growth, economists say.

Ten-year yields peaked at 3.08 percent in January, and are now at 1.87 percent. Sonia forward contracts show traders have pushed back bets for a 25 basis-point increase in the U.K. benchmark rate to beyond November. As recently as August, the market was pricing in an increase in February.

While another year of near-zero interest rates would be a boon for the economy and homeowners with mortgages, it’d be bad news for savers who rely on interest earned on deposits.

“With fiscal policy set to remain a drag on growth for many years, and with the private sector also running high levels of debt, the course of least resistance for the Bank of England is to keep interest rates at low levels,” David Scammell at Santander Asset Management, which oversees about 128 billion pounds, wrote in a client note on Dec. 8.

Investor Rewards

Gilt investors who went against the consensus this year were rewarded with returns of 13 percent. German debt handed investors 9.3 percent and U.S. Treasuries 6.1 percent, Bloomberg World Bond Indexes show.

Gilts may struggle to maintain the same momentum next year, and could fall, according to money manager Michiel de Bruin, who says the economy is strong enough for the BOE to raise rates.

“Gilts are very strong already, and have also been driven by the European situation,” said de Bruin, London-based head of global rates and money markets at F&C Asset Management Plc, which manages about 83 billion pounds. “The rally should ease off somewhat. We still have a modest bias to see 10-year rates higher in the coming months.”

Bulls were given further ammunition this week when a government report showed manufacturing output unexpectedly fell for the first time in five months in October. Exports to the euro region have fallen 4 percent over the past year and the housing market is cooling.

“As things stand, the economic outlook suggests that rates won’t be going up next year,” said Robin Marshall, London-based director of fixed income at Smith & Williamson Investment Management. Risks of deflation from lower commodity prices and a slowdown in global growth “are considerably greater than the risks of an inflationary shock requiring higher base rates,” he said.