The UK gilt and corporate bond markets have staged a strong rally since the end of June, with the FT...
The UK gilt and corporate bond markets have staged a strong rally since the end of June, with the FTSE All Stock Gilt index posting a 7.7% gain and the Merrill Lynch All Stock Investment Grade Credit index rising 9%.
Bond markets were already rallying before 11 September, as the global slowdown gathered speed. Post-11 September, the aggressive monetary easing has supported short-dated gilts, while longer-dated maturities have benefited from regulatory changes. Significantly, the introduction of accounting standard FRS 17 has prompted some pension funds to reduce their equity exposure in favour of bonds.
The anticipation of more strategic asset allocation moves, against a backdrop of light corporate issuance has further underpinned corporate bond performance. The near-term optimistic outlook for bonds is easily justified. The short end has benefited already from the low inflation environment and the disappointing data, both in the US and Europe. The market expects a further cut in UK rates to 3.5%, taking base rates to the lowest levels since the mid-1950s. Gilts will be supported in the near term by the large cashflows from the December coupon payments and the coincident index lengthening. The 2002 outlook, however, is more pessimistic for UK bonds. The extent of the reflationary policies represent a big threat to valuations. The huge monetary easing and fiscal stimulus is a reactive move and longer-term issues of inflation and growth are secondary in the present environment.
The UK economy is also better placed to withstand the global downturn. The domestic backdrop remains strong and interest rate cuts and future government spending plans should mean a recession is avoided. The economic outturn will more likey be GDP growth higher than the 1.9% consensus forecast.
The MPC will be monitoring the UK economy closely, and if there are any signs that it is not slowing, it will be quick to take back some of the recent rate cuts. Our forecast is that base rates will end next year close to 5%, as the economy recovers.
With the gilt market already pricing in a further 50bp of cuts the market is stretched. Gilts look expensive, both outright and to international markets. Gilt supply is also an issue for market participants. Unlike the US, there will continue to be issuance of long maturity bonds. The gilt market has been accustomed to government surpluses over the past five years, but with an end to the peace dividend and efforts to improve both education and health a budget deficit is increasingly likely.
With little prospect of further tax rises the deficit will be funded by more gilt issuance. We expect actual gross gilt issuance to increase from £13.5bn 2001/02 to £28bn the subsequent financial year. As a consequence we are bearish on gilts next year. The 30-year gilts now yield 4.25%, which equates to a real yield of 1.75%. Equities look cheap versus gilts, and if there are more signs of stability, it cannot be ruled out that some of the equity into bonds trades are reversed.
With events still unfolding following 11 September, markets are likely to remain volatile into the first half of 2002. However bonds, and gilts in particular, look to be close to their peak.
UK gilt and corporate bond markets rally.
Regulatory changes had positive affect.
Further strategic asset allocation moves.
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