The forces driving investors to make significant allocations to UK bonds and the low supply environm...
The forces driving investors to make significant allocations to UK bonds and the low supply environment, which has resulted in UK bonds becoming an internationally expensive asset class, may now be abating.
Over the next few months, a combination of fundamental and technical factors may conspire to put pressure on gilt yields and we are cautious in the short term. Further ahead, we are more constructive on the short to medium area of the gilt market as interest rates peak.
The electorate's dissatisfaction with the National Health Service and Education put pressure on Chancellor Gordon Brown to pre-empt the summer spending review and relax his prudent stance towards public finances. Unexpectedly, after three years of careful spending, the Chancellor provided an extra £2bn to the Health Service and is now committed to bring spending in future years nearer to European levels. This alters the medium term outlook for government borrowing and will result in higher gilt issuance.
The Debt Management Office has been proactive in attempting to alleviate the illiquidity that has been a prevailing feature of long gilts. Over half of the gilt issuance for financial year 2000/01 will be in the over 15 year maturity sector. A 2032 dated bond with an expected issue size of £2.5bn is scheduled for May. In June a switch auction out of Treasury 8% 2015 into the new issue will increase the size of this bond by another £2.0bn to £2.5bn. The gilt market is likely to be preoccupied with this supply, putting pressure on long gilt yields.
Pension funds have passed their first review deadline for MFR compliance. This will mean the large flows into gilts to meet the MFR are likely to reduce. In addition, the consultation paper regarding alterations to the MFR procedure is due to be issued by the end of April or beginning of May. This is expected to suggest that AA corporate bond yields, rather than AAA government bond yields should be used to provide the discount rate for defined benefit pension schemes. This could lead to further selling of gilts to buy higher yielding corporate bonds.
Gilt yields are also likely to come under pressure in the near term from further rises in interest rates. In the medium term, economic growth will level out in 2000 and slow to trend in 2001. We are confident that the BoE will continue to achieve its long term inflation target. This will provide a positive backdrop for gilts and yields should stabilise when the market perceives interest rates have peaked.
We expect the recent rally in UK bonds to falter as yields come under pressure from further interest rate rises and forthcoming supply. As interest rates reaches their peak and a economic growth slows down, the fundamental background will start to improve. This will limit the upside risk to gilt yields over the medium term.
Alex Jones is director of long-dated bonds at Royal & SunAlliance Investments
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