Traders expect more troubles ahead for the UK bond market

Investors are speculating that UK bond yields may return to levels seen at the height of the “mini” budget crisis last year after hot inflation data forced markets to reset their interest rate expectations.

The yield on two-year US Treasury bonds, which is highly sensitive to interest rate changes, reached 4.4 percent on Wednesday after stronger-than-expected inflation.

Yield moves sharply up from 3.7 per cent earlier this month, leaving yields poised to peak at 4.7 per cent in September in the wake of then-chancellor Kwasi Quarting’s disastrous ‘mini’ budget, which contained £45bn of Unfunded tax cuts. Wednesday’s moves also cemented the UK’s status as the worst-performing global bond market so far this year.

This time traders were re-pricing bonds and swaps after weeks of strong inflation and jobs data, exacerbating concern that the Bank of England will need to raise interest rates further to bring inflation under control. Yields rise when bond prices fall.

Paul Breen, global bond fund manager at Newton Investment Management, said he had been looking to buy gils but the sharp rise in core inflation gave him “pause for thought”.

“The market is re-pricing what the BoE is going to do,” Brin said. “We are hesitant because it takes a while for the shock to reach the market view.”

Line chart of interest rate swaps market pricing December 2023 (%) showing rising UK interest rate expectations for December

The swaps markets are pricing in three or possibly four more rate hikes to a peak of 5.4 per cent by December, a sharp increase from the expected peak of 4.8 per cent at the end of last week.

“I think there is more underperformance [of UK bonds] said Imogen Bachra, head of UK interest rates at NatWest, who now believes the Bank of England will raise interest rates to 5 per cent by the end of the year, after not forecasting any further hikes ahead of April’s inflation data.

“We could be talking about a peak above 4.5 percent for 10-year government bonds and close to that for two-years as well,” she said.

Investors are particularly worried about rising core inflation, which excludes volatile food and energy prices, which rose to 6.8 percent in April, from 6.2 percent the previous month.

Bank of England Governor Andrew Bailey acknowledged on Tuesday that there are “very big lessons to be learned” in setting monetary policy after the central bank failed to anticipate and sustain the recent surge in inflation.

While bond prices recovered last fall after the Bank of England intervened to buy 19 billion pounds of government bonds on financial stability grounds, the yield on 10-year UK debt rose from 3 per cent in February to 4.2 per cent today, approaching a “mini”. The budget peak is 4.5 percent.

Quentin Fitzsimmons, portfolio manager at US asset management T Rowe Price, said he expected the rise in UK yields after last year’s “mini” budget to be a “magnet” for bond prices.

The gold market raises the amber flag – if not the red flag – towards Kwasi Quarting-[Liz] A gear disaster and I can’t see what’s going to stop it, except in a very large slack.

Line graph of the spread of the yield on UK 10-year government debt over Germany (percentage point) showing a widening gap with Europe

UK bonds have performed worse than other large bond markets this year, as evidenced by the widening “spread” – or yield differential – between the US and Europe, a sign that investors are asking for a premium for UK bonds.

But some investors viewed the sale as a buying opportunity. “We’ve gone long on our gold funds for the first time in five years,” said Craig Inches, head of interest rates and cash at Royal London Asset Management.

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