Investors looking to escape the bear market in equities inevitably turn to government bonds, and mos...
Investors looking to escape the bear market in equities inevitably turn to government bonds, and most markets have posted good returns so far this year. Economic data and the path of interest rates will continue to weigh on the markets, but technical factors will also play a part.
Gilts started the year strongly, with yields falling in response to expectations of rate cuts and a benign inflationary outlook. The short end has proved particularly attractive and yields have fallen as a result. But with one-year yields now below 5%, this sector of the curve looks fully valued given the more upbeat economic picture in the UK compared with the US. Key data, such as retail sales and consumer confidence, have yet to signal the slowing consumer demand that has spooked the Fed, and will be further boosted by the pre-election budget which represents the biggest fiscal easing by any G7 country this year.
Further out on the curve, there has been a dramatic shift in the relative yield levels of medium and long-dated gilts because of a changing technical outlook. Long gilt prices have been kept artificially high in recent years due to a supply-demand imbalance caused by the minimum funding requirement (MFR), which requires UK pension funds to hold a given amount of their assets in long gilts. The Chancellor announced in his budget that he intends to support the scrapping of the MFR and with their technical support crumbling, long gilt prices have tumbled. With long yields still below the yields on medium gilts, this move looks as if it may have some way to go and is a very popular medium-term view.
In the US, the Treasury curve has steepened in response to the series of 0.5% rate cuts, and as in the UK, shorts look to be fully priced. But during the last loosening cycle in 1998, two-year Treasury yields bottomed by more than 0.75% below the trough in the Fed funds rate, so there may still be value to be had.
Long Treasuries have sold off relative to the middle of the curve. This is down to general steepening and because the scarcity premium which they picked up last year in response to the buyback programme has been eroded as the effects of the proposed $1.6 trillion tax cut on the paying down of the national debt weigh on the market. Developments in Europe have followed the US to a degree, with the safehaven flows into government bonds being the inevitable response to equity weakness. Unlike the US, though, rates in Euroland look firmly on hold due to stubbornly high inflation which gives the Central Bank little room to manoeuvre.
Inflation is likely to fall later in the year, and it is hoped interest rates will follow, but with some tightening already priced in, the market looks optimistic. Benign inflation also depends on a stable, if not appreciating euro, as well as continued weaker energy prices, so these will be key developments for European bonds over the next few months.
Danny Oswald is fixed interest analyst at Scottish Life
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