UK borrowers won a short reprieve last week as gilt yields dropped. The trigger wasn’t domestic factors, but a weak set of jobs data in the US. The UK bond market continues to, more or less, track the US bond market. It assumes the Bank of England remains bound to the Federal Reserve on rates cuts, in spite of a markedly different economic picture in the UK versus the US.
Gilts remain a little lower than US treasuries, with the 10-year gilt yield at 4.2% and 10-year treasury at 4.5%, but the two have moved largely in lockstep. UK gilts moved sharply on news that the US added just 175,000 jobs in April, well below the 241,000 forecast in a Bloomberg poll and the smallest rise for six months, but have been seemingly less interested in weaker domestic inflation data or sluggish GDP growth.
Gilts are also grappling with a ‘bear steepening’, says Gael Fichan, head of fixed income at Syz Group, where long-term yields rise faster than short-term ones as interest rates expectations are pushed out further. She adds: “The Bank of England’s actions are closely tied to the Federal Reserve and the timing of potential rate cuts relative to the Fed will be crucial.”
Bonds markets have no problem believing that the eurozone will cut before the Federal Reserve, but seem wedded to the idea that the UK is unlikely to cut before the Federal Reserve. This is in spite of different inflation and growth paths.
UK inflation is widely expected to drop below 2% over the coming months. Robert Alster, chief investment officer at Close Brothers Asset Management, says: “CPI is expected to slow markedly in April, when the Ofgem price cap falls by 12%, and this is expected to bring CPI below 2% through the second and third quarters.”
Mark Preskett, portfolio manager at Morningstar Wealth, agrees: “We’ve even seen some reports that UK inflation could fall as low as 0.5% next year. Consensus forecasts for inflation are coming down quite fast in the UK. Also, the Bank of England doesn’t want to crash the housing market, so the incentive is to cut rates.” In contrast, the US economy is showing real strength and pricing pressures have proved persistent.
CPI wobbles
That is not to say that there aren’t other factors at work in higher gilt yields. The recent CPI report in the UK showed some wobbles, which may have led some market participants to assume that UK inflation might prove as stubborn as US inflation. The data for March showed a more modest drop than expected, with inflation slowing to 3.2% from 3.4%, but stronger than the consensus forecast of 3.1%. The data moved market expectations, just not as much as the US jobs numbers.
Stronger economic data may also be a factor in keeping gilt yields high. The latest UK PMI figures in both services and manufacturing have shown surprising strength. Recent consumer confidence surveys have also been positive, helping by still-strong wage growth.
Demand could play a role. The UK’s debt burden is high, and it is not master of its own destiny in the same way as the US. If investors start to lose faith with the direction of government policy (another ‘Liz Truss’ moment), it may affect demand for the gilts and push yields higher. However, this doesn’t appear to have happened yet. In the last gilt auction, the Debt Management Office (DMO) said that £4bn ($5.01bn) worth of five-year bonds priced at 4.29% were 3.2x over-subscribed.
Decoupling
There is no reason why the Bank of England cannot move before the Federal Reserve, says Preskett and he believes it is likely to do so. “It has moved independently from the Federal Reserve a few times in the past, even if the Fed will usually move first.” Morningstar’s current projections are for a long-term gilt yield of around 3.6%. Plenty of other central banks have decoupled from the Federal Reserve with little consequence. The Swiss National Bank, for example, has cut rates, while Australia may still raise rates.
There are risks to sterling from divergence, but the UK has lived with a strong dollar for many years. Equally, there are many other factors weighing on the currency, such as the UK’s balance of payment problems and debt issues. “It is much more complex than just an interest rate differential,” Preskett says.
Against this backdrop, fund managers increasingly believe there is value in gilts. Preskett says that although there remains a lot of volatility in bond markets, Morningstar’s long-term expectation is that inflation will fall and rates will come down: “We are overweight duration and added to duration in the recent sell-off.”
Ariel Bezalel, manager of the Jupiter Strategic Bond, is also positive: “In the coming months, we should see UK inflation undershoot the 2% target, paving the way for the Bank of England to cut rates in June.” He has also been topping up on gilts, which – he says – are “very attractive at these yields”.
The Bank of England’s May Monetary Policy Report will be crucial says Alster. He adds: “If inflation softens as expected, it is likely that the Bank’s forecast will see CPI, conditioned on the market-implied path of rates, at or below 2% at the end of the three year forecast period. This would open the door for interest rate cuts. The fact that the market implied path has shifted to anticipate a first cut in August, as opposed to June, makes it more likely that the forecast will predict that the price stability mandate will be met, while at the same time delaying the likely timing of rate cuts to August or later.”
Either way, there is no reason that the path of UK interest rates should be wedded to that of the US. Markets may increasingly start to diverge as CPI data starts to diverge. Gilt funds have had a difficult run, falling 3.7% since the start of the year and this shift would be welcome.
This story first appeared on our sister publication, Portfolio Adviser.
