By Philip Poole
Long term UK government bond yields have risen by almost 30bps over the past month raising the question of whether gilts have ‘lost their shine?’ In 2012 UK government bonds benefited from a number of supportive factors that had the effect of depressing nominal and real yields to historically low levels. But these supporting factors are now fading.
Bank of England (BoE) bond buying through quantitative easing (QE) has clearly been an important supporting factor. Unlike the Bank of France or the Bank of Spain, the BoE runs an independent monetary policy and has been in a position to buy substantial amounts of its own government’s paper. As a result of this asset purchase programme the BoE now owns approximately 30% of the entire gilt market.
This is a much higher proportion than other markets where central banks have been buyers of their own government’s debt. The BoE’s holding of gilts purchased through QE are now larger than those of domestic pension funds and insurance companies combined. But it looks like large scale gilt purchases from the BoE could be a thing of the past. The BoE’s monetary policy committee (MPC) voted 8-1 in January in favour of keeping the existing QE programme unchanged.
For much of 2012 the gilt market was treated as a pseudo safe haven asset market, despite underlying fundamentals that were not exactly supportive. As such it benefited from investor flows that were avoiding fixed income markets in Europe. Foreign investors now own about £400bn in gilts, equivalent to one-third of the entire gilt market.
However, the European Central Bank (ECB) initiative to set up the Outright Monetary Transactions (OMT) asset purchase programme has created an effective backstop that has reduced the tail risk of a premature eurozone break-up. Safe haven demand for gilts is likely to continue to fade as a result. The recent weakness of sterling, if it is expected to continue, is another factor that will likely deter foreign investors from putting more money into the market, having the effect of both reducing gilt returns in other currencies and putting upward pressure on inflation via rising import costs.
Then there are the poor underlying economic fundamentals in the UK. Activity levels remain very weak, as evidenced by the Q4 GDP release. While weak activity is normally accompanied by downward pressure on inflation this has not been the case in the UK. In fact the Bank’s 2% inflation target seems to be moving further out of reach. The BoE has extended the period it is prepared to accommodate above target inflation. Now it does not expect inflation to fall to its 2% target until 2016 at the earliest. The upward revision in inflation was driven mainly by sterling weakness and a more robust outlook for energy prices. Economic growth forecasts were simultaneously revised down to 1.3% for Q4 2013 compared to 1.7% in November. This combination seems like a perfectly valid reason for investors to demand a higher yield for holding gilts.
While it may not be particularly evident yet in the data out of Europe, the global economic cycle is improving and this is likely to lead to a continued rotation of invested funds out of government bonds into riskier assets such as equities and credit, where prospective returns look more attractive. With safe haven and liquidity preference set to further diminish as supportive factors for gilts, higher yielding assets look likely to attract fund flows from gilts.
The large expected change in supply net of redemptions and QE (from £51bn in 2012 to £84bn expected in 2013) looks set to put additional upward pressure on gilt yields. For this reason, we maintain an underweight position for UK government bonds in our global fixed income portfolios.
Philip Poole is global head of macro and investment strategy at HSBC Global Asset Management
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