Rally in U.K. Inflation-Linked Bonds Seen Losing Steam in 2017

  • Return on linkers more than twice that of gilts this year
  • Break-even rate close to highest level since January 2014

Investors enjoying their best returns in five years on U.K. inflation-linked securities shouldn’t get too complacent.

The 10-year break-even rate, a gauge of expectations for retail prices over the next decade, climbed last week to the highest since January 2014, as the pound’s plunge since Britain voted to leave the European Union helped pushed up import costs. While the outlook for faster inflation boosted so-called linkers, which have returned more than double that earned on conventional gilts this year, the rally might be running out of steam.

“There has been a lot of news on the rise in oil prices and weakness in the currency,” said Vatsala Datta, a rates strategist at Royal Bank of Canada in London. “Everything is in the price already, so even though the backdrop generally will be quite supportive for breakevens, U.K. breakevens in particular can moderate from here.”

Yields on conventional government bonds have been rising amid speculation that Donald Trump’s victory in the U.S. presidential election last month will lead to an expanded fiscal policy, helping support growth and faster inflation.

U.K. linkers have returned about 21 percent this year, set for the biggest gain since 2011, while gilts -- the best-performing sovereign securities among the Group-of-10 economies -- have earned 8.9 percent, according to Bank of America Corp. indexes.

It’s this outperformance that makes strategists skeptical of continued growth in returns. The real yield on 10-year linkers was little changed at minus 1.76 percent in London Thursday, having reached a record low of minus 2.205 percent in October. The 10-year break-even rate was at 3.01 percent, after climbing to 3.16 percent on Dec. 15.

‘Sharp Move’

Linkers “have moved a long way,” said Graeme Caughey, Edinburgh-based head of pan-euro fixed income at Aberdeen Asset Management, which manages around 312 billion pounds ($386 billion.) Caughey said that while he owned inflation-linked bonds, as they kept rising “we thought actually that is quite a sharp move very fast, probably not all based on fundamental valuations.”

While Bank of England Governor Mark Carney signaled earlier in this month that officials were willing to tolerate a period of faster inflation, the pound’s weakness may mean that stance could change. The U.K. currency has slumped almost 17 percent versus the dollar since Britain voted to leave the EU in June and touched a 31-year low in October.

It’s becoming more likely that the BOE will act to slow inflation next year by raising interest rates. Swaps pricing shows the odds of a rate hike by the end of 2017 are about 35 percent, compared with 6 percent on Sept. 30.

“You’re going to get inflation picking up next year and potentially the year after that,” said John Wraith, head of U.K. rates strategy at UBS Group AG in London. “But then it’s going to fall away because demand is going to be hurt over that period in the domestic economy.”

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