Investors are forecasting that UK gilt yields could return to levels seen at the peak of last year’s “mini” Budget crisis after hot inflation data forced markets to reset their interest rate forecasts.
The yield on two-year gilts, which is highly sensitive to interest rate changes, hit 4.4 per cent on Wednesday following stronger than anticipated inflation.
The yield moves marked a sharp rise from 3.7 per cent earlier this month, leaving yields heading towards the 4.7 per cent peak last September in the wake of then-chancellor Kwasi Kwarteng’s disastrous “mini” Budget, which contained £45bn of unfunded tax cuts. Wednesday’s moves also reinforced the UK’s position as the worst-performing major global bond market so far this year.
This time traders have been repricing bonds and swaps after weeks of strong inflation and jobs data, exacerbating concern that the Bank of England will need to increase rates further to bring inflation under control. Yields rise when bond prices fall.
Paul Brain, a global bond fund manager at Newton Investment Management, said he had been looking to buy gilts but the sharp rise in core inflation had given him “a bit of pause for thought”.
“The market is repricing what the Bank of England will do,” Brain said. “We are being hesitant because it takes a while for the shock to feed through into the market view.”
Swaps markets are pricing in three or possibly four more interest rate rises to a peak of 5.4 per cent by December, a sharp increase from an expected peak of 4.8 per cent at the end of last week.
“I think there is further underperformance [of UK bonds] to come,” said Imogen Bachra, head of UK rates at NatWest, who now thinks the BoE will raise interest rates to 5 per cent by the end of the year, having not forecast any more rises ahead of April’s inflation data.
“We could be talking about a peak above 4.5 per cent for 10-year gilts and close to that for 2-year as well,” she said.
Investors are particularly concerned about the rise in core inflation, which strips out volatile food and energy prices, which rose to 6.8 per cent in April, from 6.2 per cent the month before.
BoE governor Andrew Bailey on Tuesday conceded that there were “very big lessons to learn” in setting monetary policy after the central bank failed to forecast the recent rise and persistence of inflation.
While bond prices recovered last autumn after the BoE stepped in to buy £19bn of gilts on financial stability grounds, the yield on 10-year UK debt has risen from 3 per cent in February to 4.2 per cent today, and close to the “mini” Budget peak of 4.5 per cent.
Quentin Fitzsimmons, a senior portfolio manager at US asset manager T Rowe Price, said he expected the rise in UK yields following the “mini” Budget last year to act as “a magnet” for bond prices.
“The gilt market is putting up an amber flag — if not a red flag back — towards the Kwasi Kwarteng-[Liz] Truss disaster and I can’t see what will stop it, short of a very substantial recession,” he said.
UK bonds have performed worse than other big bond markets this year, which is evident in the widening “spread” — or difference in yield — between the US and Europe, an indicator that investors are demanding a premium for UK bonds.
But some investors have viewed the sell-off as an opportunity to buy. “We have gone long duration in our gilt funds for the first time in five years,” said Craig Inches, head of rates and cash at Royal London Asset Management.
