Gilts a No-Go at BlueBay as Inflation Eclipses Brexit Drag

  • Fastest inflation since 2013 seen eroding returns on U.K. debt
  • Ten-year yields forecast to climb to 1.54% by year-end: survey

Even the threat of a burdensome Brexit may not boost the U.K.’s bond market.

Yields on 10-year gilts have crept back higher to 1.12 percent after briefly dipping below 1 percent last month, and may rise to 1.54 percent by year-end, according to the median estimate of analysts surveyed by Bloomberg. BlueBay Asset Management sees the climb extending to as high as 2 percent, while Deutsche Bank AG expects a level between 1.6 percent and 1.7 percent.

Britain’s fastest inflation since 2013 is eroding bond returns, with no prospects yet of the Bank of England cutting interest rates even as the nation’s exit from the European Union threatens to hurt the economy. The Bloomberg U.K. Sovereign Bond Index has retreated 4.5 percent from a record high in August.

“Gilts look one of the worst assets you could actually survey on the planet,” Mark Dowding, co-head of investment-grade debt at BlueBay Asset in London, said in a telephone interview. “It’s like the market is sending this message that in the next fifty years -- for the rest of my life -- we’ll never see rates go above 1 percent,” he added, referring to the current pricing of 50-year interest-rate swaps at 1.32 percent. “That is plain ridiculous.”

Even evidence that Brexit is beginning to harm the economy isn’t really lifting demand for the safety of government debt. Recent data releases showed the worst economic performance in a year, retail sales falling the most in seven years and the normally buoyant housing market stagnating.

The two-year Brexit process triggered in March now looks set to turn increasingly acrimonious, with Prime Minister Theresa May suggesting this week that European Commission President Jean-Claude Juncker may discover that she can be “bloody difficult.”

Inflation Risk

Inflation stemming from the 13 percent drop in the pound since the vote to leave the EU has started to filter through into the economy, with consumer prices rising at an annual pace of 2.3 percent in both February and March. That’s the fastest since September 2013 and higher than the BOE’s target. Economists surveyed by Bloomberg expecting it to increase to 2.8 percent in the second half of the year.

Some are less convinced by the durability of sterling-induced price increases. For Investec Asset Management, inflation will only have a significant bearing on gilts if it’s be accompanied by second-round effects such as higher average earnings.

“We have been long on short-dated gilts for several months now and think we will re-visit the lows in yields seen in the aftermath of last August’s rate cut,” Investec portfolio manager Russell Silberston said in emailed comments. “Unless rising inflation is accompanied by clear second-round effects such as higher average earnings or inflation expectations, then it is only a drain on real incomes.”

Deutsche Bank said the BOE will have to respond to steadily rising price pressures at some point, pushing gilt yields higher, even if the economy slows further.

“The market is generally pricing the Bank of England as being too dovish and it hasn’t taken into account the fact that you’ve got these higher inflation prints,” Deutsche Bank strategist Jack Di-Lizia said in a telephone interview. “We don’t think that policy mix is really appropriate.”

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