Investors familiar with developments in the gilt market will know that long gilts and index-linked g...
Investors familiar with developments in the gilt market will know that long gilts and index-linked gilts were the best performing parts of the curve last year, both posting positive returns in a bear market when 10 year yields rose by 1.1% and 5 year yields by 1.5%. Tight fiscal policy, MFR, and hedging guaranteed annuity options all impacted on the free-float of gilts and the curve has been severely distorted as a consequence. The wider dealing costs explicit in a more volatile market and the reduced capital committed by brokers have reduced trading volumes and the participation of real money managers has been low.
The global environment for bonds remains poor. The resynchronisation of growth is pushing up commodity prices and pressurising central banks to tighten monetary policy. Competition, e-commerce, corporate restructuring in Europe and Japan and spare capacity in Asia and emerging economies has so far ensured that goods price inflation has remained benign. Pockets of pressure in both the UK and US labour markets where unemployment has fallen to new lows for the cycle and in the UK housing market, up13% in 1999, are emerging and undermining some of the hard fought credibility which Fed Chairman Greenspan and the MPC have won in recent years. However, forward interest rate markets discount an aggressive tightening of policy (ex-Japan) which offers some protection at current yields, unless underlying inflation does pick-up this time. UK rates are expected to reach 6.75% by end 2000 and go higher in 2001. This looks too pessimistic but is a reflection of the MPC's adherence to average earnings and house prices as their lodestar at the expense of overall monetary conditions. Sterling strength may well result in a lower path for rates but at the very least will contain pipeline inflation pressures for a little longer.
Although the Chancellor has maintained an iron grip on fiscal policy there is a strong case to be made to increase taxation on the personal sector to rein-in consumer activity and redeploy resources to the public sector - not least to meet manifesto commitments in the key areas of health, education and transport. Prime Ministerial commitments to raise real spending on health are unnerving for markets but the reality is that the strength of economic growth and classic smoke and mirrors will satisfy two very different audiences: that policy remains prudent and that cash is being targeted on the needy.
The arcane subject of MFR has been a positive influence on gilts since its introduction in 1997 as defined benefit pension schemes have increased their allocation to bonds. In part this has contributed to the acute shortage of gilts as pension funds have locked-up stock. The review of MFR is due to be submitted to the DSS by April and is the subject of much rumour and misinformed comment. One possible outcome is that mature liabilities will be discounted using a AA corporate bond yield instead of a long gilt yield, thus weakening the MFR basis. While this would assist underfunded schemes it would also encourage Trustees to switch from gilts to corporates and partially alleviate the demand/supply imbalance.
Although the markets discount a sharp tightening in policy, any rally will need to await validation of higher rates or more tangible evidence that activity levels are peaking. Until then markets are likely to trade defensively awaiting a clearer catalyst to move to lower yields. Our portfolios have maintained exposure to long gilts and selectively added high quality corporate bonds where spreads are historically wide.
Alan Wilde is investment manager of fixed interest at Scottish Mutual
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