UK yields are still the highest among Group-of-Seven nations, but the gap is narrowing thanks to a surge in market bets on interest-rate cuts.
(Bloomberg) — October was an unusually good month for the UK bond market.
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Gilts posted their best performance in almost two years, and investors including Aberdeen Group Plc, Fidelity International and JPMorgan Asset Management are betting on more gains. Goldman Sachs Group Inc. analysts have slashed their yield forecasts, citing easing inflation pressures and signs Chancellor Rachel Reeves will announce tough steps needed to get the budget in order.
Expectations for more Bank of England interest-rate cuts are powering the move. If a small — but growing — band of strategists are correct that officials will deliver a surprise cut at a meeting this week, the remarkable rebound that’s put UK bonds at the front of a global rally will likely pick up pace.
“It’s always been a question of when inflation is going to start coming down and there are now signs that’s starting to happen,” said Seamus Mac Gorain, global head of rates at JPMorgan Asset Management, who said he is overweight gilts. “It’s pretty likely that the package that the chancellor announces is helpful to the gilt market.”
Ever since Liz Truss’s unfunded budget plans unleashed an historic selloff that led to her ouster three years ago, the nation’s turbulent debt markets have loomed large. They’ll remain a political football ahead of Reeves’ budget on Nov. 26, when she’s expected to announce tax rises in order to keep on the right side of her fiscal rules.
UK yields are still the highest among Group-of-Seven nations, but the gap is narrowing thanks to a surge in market bets on interest-rate cuts.
While the BOE cites stubborn price pressures as the reason it hasn’t cut as much as the European Central Bank, the latest data challenge that narrative.
CPI Surprise
UK inflation unexpectedly held steady rather than quickening in September and separate figures last week showed food prices fell the most since late 2020. Meanwhile, Governor Andrew Bailey — a key swing voter on the nine-member Monetary Policy Committee — has raised concerns about the UK economy running “under potential” and a softening jobs market.
Money markets are now pricing 60 basis points of rate reductions over the next year, compared with around 40 basis points at the start of October.
Some banks, including Barclays Plc and Goldman Sachs, predict the BOE will cut at its Thursday decision. Interest-rate swaps suggest investors think the next reduction is more likely in December or February.
“Gilts are part of our developed market exposure because it’s one of the markets that has been particularly beaten up,” said Huw Davies, an investment manager at Jupiter Asset Management. “At some stage, the weakness in the UK economy will allow the BOE to be at least more dynamic about interest-rate cuts.”
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November’s budget is also helping gilts by fueling expectations that potential tax rises and spending cuts will hurt economic growth.
It’s the “single biggest event for UK fixed income,” of the year, said Steve Williams, head of EMEA global fixed income at Amova Asset Management.
A key Labour election pledge to not increase the nation’s big three taxes appears increasingly in doubt.
While this is likely to be unpopular with voters — and is hurting the pound — bondholders are reassured because it shows the government’s commitment to matching day-to-day spending with tax revenue — one of its core fiscal rules.
“The UK does not have the ability to do massive fiscal stimulus,” said Mike Riddell, a fund manager at Fidelity who said gilts are his preferred choice among developed-market issuers. “The UK relative to other countries feels almost like austerity.”
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To be sure, the speed of the recent drop in yields could be a reason for caution. The rate on 10-year gilts trades at 4.41%, down from a high of 4.85% in early September.
Volatility Ahead
Fidelity’s Riddell said that while he’s still overweight gilts, he had taken some chips off the table after the recent rally. Harvey Bradley, Co-Head of Global Rates at Insight Investment, said he is neutral because of concerns the market is over-positioned for further gains.
Others are outright bearish, citing the likelihood of another budget-driven selloff.
“I still think that we can have more volatility and that gilt yields can spike higher, especially in the run up to the budget,” said David Zahn, head of European fixed income at Franklin Templeton. He doesn’t own gilts in any of his European accounts, and is sticking to his prediction for the UK 30-year yield to rise to 6% from around 5.2% currently.
Even after recent gains, the Bloomberg gilt index is over 25% from its high watermark, with the market’s longer-than-average duration hurting performance. Yet it’s precisely because gilts have taken such a battering that they appear attractive to bargain hunters willing to ride out bouts of volatility.
“We’ve been hurt a few times by rogue headlines,” said Matthew Amis, fund manager at Aberdeen, citing the sudden July selloff on speculation the chancellor might leave her position. “But I think Reeves can deliver a good budget.”
–With assistance from Alice Atkins, Naomi Tajitsu, James Hirai, Kit Rees and Alice Gledhill.
