The current UK yield curve is sharply inverted, in marked contrast to the Euroland bond markets. Sho...
The current UK yield curve is sharply inverted, in marked contrast to the Euroland bond markets. Short-dated gilts offer a yield of around 6%, whereas their long-dated counterparts offer a meagre 4.25%. In Euroland, long bonds yield around 5.5%. What has caused this disparity to occur? Is there any value left in long gilts?
UK bonds have generally lost ground throughout 1999 as concerns over higher global inflation have increased on the back of continued strong US economic growth allied to recovery in the rest of the world.
Short-dated gilts bore the brunt of the pain, as uncertainty over the interest rate outlook caused investors to run for cover. At the long-dated end of the market the story has been somewhat different, as strong institutional demand from UK pension funds and life insurance companies provided significant support.
These two large investor groups have significant long-term fixed rate liabilities and, as a result, they have been forced to nail their colours steadfastly to the long-dated gilt mast.
Further encouragement for pension funds to invest in long-dated gilts has come from the Minimum Funding Requirement, and to compound matters these strong levels of demand have been met by sparse supply due to the improving public finance position. The result of these market developments is a steeply inverted UK yield curve.
The inverted UK yield curve appears set to remain in place, particularly as the paucity of long-dated gilt supply is set to persist as the Government's fiscal position continues to improve in 2000.
The domestic economy is in reasonable shape, as the Monetary Policy Committee's (MPC) rapid rate cuts in late 1998 and early 1999 have helped it to stage a robust recovery. The MPC is expected to prove as proactive in raising rates as it was in cutting them and early validation of its aggressive tactics has been provided by two recent rate hikes.
This pre-emptive move to keep inflation under control is likely to be followed by more of the same in the coming months. Short gilts are likely to gag on the monetary medicine and yields there will rise further.
However, long gilts will draw comfort from the belief that the MPC has a firm hand on the tiller, as the early action should keep long term inflation under control. With the yield on long-dated UK gilts hovering just over the 4% mark, prospective investors must ask themselves if there is sufficient long-term value in these investments to justify dipping into the coffers.
A patchy economic recovery and a European Central Bank that seems likely to be just as determined to control inflation as the MPC provide further compelling reasons to look to the continent. Index-linked gilts have outperformed conventional gilts over 1999 thus far, as similar forces to those driving the long-dated end of the conventional market have been in place but to an even greater extent.
Liability driven institutional demand has continued to far outweigh inadequate government supply, causing index-linked yields to return to record lows registered in the early stages of the year. Current yields of around 2% are unattractive when compared to the ever maturing US Treasury Inflation Protection Securities market, where a yield of nearer 4% is on offer. The forces that have made UK gilts expensive are likely to remain in place and support the market for some time.
Martin Hall is head of fixed income at Norwich Union Investment Management
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