U.K. Debt Seen Losing Edge Over Euro Area as Rate Increase Looms

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U.K. government bonds risk losing their status as the least bad performers in Europe as the Bank of England moves closer to ending emergency stimulus.

Unlike the European Central Bank, which is set to continue its monthly 60 billion-euro ($66 billion) bond-buying plan until September 2016, officials in the U.S. and Britain are debating when to increase record-low borrowing costs. Economists predict the Federal Reserve will act in September, with the BOE following early next year.

That may weigh on gilts, which lost less than debt from every euro-region sovereign in May. Royal Bank of Canada expects investors to begin demanding a bigger yield premium to hold 10-year U.K. debt instead of similar-maturity German bunds. The so-called spread has narrowed to 130 basis points from as much as 162 in early March.

“It is ultimately monetary-policy expectations” that will drive spreads, said Vatsala Datta, a U.K. rates strategist at RBC in London. “As the Fed approaches rate hikes, U.K. gilt yields are expected to be pulled higher along with Treasuries, while bunds are not going anywhere with the ECB in action.”

The yield on 10-year gilts will climb to 2.03 percent by the end of this year, and 2.39 percent by June 2016, according to the median estimate of analysts surveyed by Bloomberg. The yield was at 1.81 percent at 12:20 p.m. London time on Thursday.

Bond Selloff

Government bonds around the world, which had been boosted by years of central-bank stimulus, began tumbling in April as investors turned against record-low yields. Losses for gilts were limited this month by U.K. inflation falling below zero and Prime Minister David Cameron’s surprise election victory, which ended weeks of political uncertainty and cleared the way for deeper budget cuts than the opposition Labour Party had proposed.

With his Conservative Party vowing to eliminate a budget deficit equal to almost 5 percent of gross domestic product by 2018, gilt issuance will be lower than it would have been under Labour, strategists at ING Bank NV, including Amsterdam-based Jeroen van den Broek, wrote on May 8.

U.K. securities lost less than 0.1 percent this month, compared with a 1.5 percent decline in German bonds and a 2.1 percent drop in Spanish debt, according to Bloomberg World Bond Indexes. Treasuries fell 0.5 percent.

There were “some short positions in gilts being run into the election that then needed covering,” said Jason Simpson, a fixed-income strategist at Societe Generale SA in London. “That has been the main driver. The big performance has come versus bunds.”

‘Pretty OK’

Some analysts remain upbeat about the prospects for U.K. debt.

“Relative to other world bond markets gilts look pretty OK,” Mark Burgess, chief investment officer at Colombia Threadneedle Investments, which has about 341 billion pounds ($520 billion) of assets under management, said on Bloomberg Television on May 27. “We think sterling is set fair, inflation is very, very contained, growth is robust, the public finances look in better shape than they do in many other countries.”

The BOE expects spare capacity -- the economy’s room to grow without triggering faster inflation -- to be erased within a year. Economists predict officials will raise the benchmark rate from 0.5 percent in February and interest-rate forward contracts are almost fully pricing in an increase by mid-2016.

Also on the horizon is a referendum on whether Britain should stay in the European Union, which Cameron has promised to hold by the end of 2017. Business leaders are urging the government to hold the vote earlier to avoid hurting investment.

“I’m not sure that I see a big trend there to be honest,” Simpson said, referring to the outperformance of gilts. “The ECB is buying bunds which should provide quite a lot of support, while gilts will be vulnerable if the tone to Treasuries deteriorates.”

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