Gilts Among `Best Shorts' as U.K. Reflation Trade Alive and Well

  • U.K. bonds should sell off most on reflation bets: Old Mutual
  • Sell 10-year gilts with target yield of 1.5 percent: UniCredit

The reflation trade looks set to make a comeback. Well, at least in the U.K.

The recent rally in gilts is starting to look stretched and selling the securities now offers a “fantastic” risk-reward opportunity, according to Mark Nash, the head of global bonds at Old Mutual Global Investors. Pacific Investment Management Co., Societe Generale SA and Mizuho International Plc said in the past week that U.K. yields should head higher, given little scope for monetary easing as inflation accelerates.

Demand at an auction of benchmark 10-year gilts declined to the lowest this year on Tuesday as yields on the maturity fell just shy of 1 percent, extending a two-month slide. While the latest push lower in gilt yields came in response to the official triggering of Brexit and a government-debt rally across other developed markets, UniCredit Bank AG says the trend should soon reverse amid increasing price pressures in the U.K. economy.

“U.K. bonds are one of the best shorts out there,” Nash, whose firm oversees about $37 billion, said in a telephone interview. “As we move away from Brexit being the main concern to more of global reflation and what that means for the U.K., it could guide gilt yields higher. We are short duration overall and short gilts within that call. That’s the market we think should sell off the most” due to the reflation trade, he added. A short position is a bet that an asset will decline in value.

The yield spread between 10-year U.S. Treasuries and similar-maturity gilts widened to as much as 138 basis points in March, the most since at least 1989, as U.K. bonds gained more. The decoupling between the two markets, with gilts outperforming Treasuries “sharply” since the Brexit vote, may signal investors expect the Bank of England “to stay on hold for longer in case there is a sizable slowdown in U.K. growth,” analysts at UniCredit, including lead U.K. economist Daniel Vernazza, wrote in a client note.

“With inflation grinding higher, this would prove quite controversial,” they wrote. “We would therefore suggest go short 10-year gilts with a target of 1.50 percent and a stop at 1 percent.”

Gilt Yields Nearing 1% May Spell Fatigue as Inflation Risk Looms

Yields on 10-year gilts were little changed at 1.10 percent at 11:34 a.m. in London, having dropped to 1.03 percent on Tuesday, the lowest in almost six months. U.K. sovereign bonds handed investors a return of 1.8 percent this year as of Wednesday, compared with 0.9 percent on U.S. debt, according to Bloomberg World Bond Indexes.

Ten-year gilt yields rising to 2 percent by end-2017 is a “fair target,” Old Mutual’s Nash said, while adding that “the sky is the limit on gilt yields” if the U.K. economy continues to grow at a decent clip.

“High inflation, strong survey data and some more hawkish rhetoric from BOE members –- and the market isn’t pricing hikes until mid-2018,” he said. “The risk-reward is fantastic betting on this before we even look at the global situation.”

— With assistance by John Ainger

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