Britain's Bonds Seen Pushing the Limits With World-Beating Climb

  • U.K. sovereign returns exceed most developed-market peers'
  • Market pricing of BOE liftoff in 2017 overdone: UBS Group

It’ll be tough for U.K. government bonds to sustain their stellar start to 2016.

The 2.3 percent return has beaten that of most developed-market sovereign bonds, as traders pushed back bets on when the Bank of England will end almost seven years of record-low borrowing costs. Governor Mark Carney said on Tuesday that “now is not yet the time” for higher interest rates in the U.K., whose government debt has also benefited by investors opting for its relative safety as stock markets and commodity prices tumbled.

This spell is unlikely to last, according to Graeme Caughey, Edinburgh-based head of pan-euro fixed income at Aberdeen Asset Management, which manages around 283 billion pounds ($402 billion).

“Markets have completely gone off the idea that BOE rates will pick up in May or in fact pick up at all this year,” Caughey said. “The pricing is way out in 2017 now,” which is the fundamental reason for the rally in U.K. bonds. For this to continue “would require further negative news from the U.K. relative to others, and I am not so confident about that.”

Britain’s debt market has surprised investors in the new year. Initial investor concerns that bonds may be hurt by the looming referendum on whether the country should stay in the European Union have taken no shine off gilts. In fact they have helped further subdue the U.K. rates outlook and pushed yields lower, propelling the nation’s sovereign bonds to the top of the stack.

The gilt return of 2.3 percent this year beat that of U.S. Treasuries and German bonds, which respectively earned 1.5 percent and 1 percent, according to Bloomberg World Bond Indexes.

The 10-year bond yield was at 1.70 percent as of the 5 p.m. London close Tuesday, down from 1.96 percent at year-end.

Even so, U.K. bonds have already begun to show signs of fatigue. The yield difference between 10-year gilts and similar-maturity German equivalents was at 1.15 percentage point on Tuesday, from 1.12 percentage point at the end of last week, which was an 11-month low. The pound has weakened about 3.8 percent versus the dollar in 2016.

Forward contracts based on the sterling overnight index average, or Sonia, aren’t pricing in a quarter-point increase to BOE rates until after March 2017, data compiled by Bloomberg show.

Overdone Rally

Faltering inflation expectations also helped the bonds, whose fixed payments are more valuable in times of slow inflation.

Even then, the gilts rally is “overdone,” according to John Wraith, the head of U.K. rates strategy at UBS Group AG in London. “To say the BOE are not going to raise rates for the next two years or thereabouts -- which is what’s priced in right now -- is a little bit premature.”

Wraith said investor anxiety over China’s market turmoil and commodity weakness has moved U.K.’s bonds and currencies more than other markets. “The extent of that repricing and the fact that it is more severe than what we’ve seen elsewhere doesn’t make sense.”

It’s a view shared by Jason Simpson, a London-based fixed-income strategist at Societe Generale SA, who said markets “are pricing in quite a bleak scenario” by delaying rate expectations into 2017. He expects the outperformance to fade.

“To push the market any further would mean a complete catastrophic outcome where oil plunges further and equity markets collapse. That is not our house view.”

Risks Crystallize

Even the risk of Britain leaving the EU, which weighs on U.K. assets, doesn’t support current levels in gilts, according to UBS’s Wraith. “For it to become fundamentally sustainable you will have to see some of these risks crystallize,” like at the very least a date being set for the referendum, and opinion polls suggesting a “very close result.”

Should domestic data in the U.K. start showing signs of strength, or global markets calm down, Britain’s bonds would take a hit, Wraith said. The rally “has already gone too far.”

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