It has been a tough year for UK bond investors and the outlook is only getting tougher, with the sho...
It has been a tough year for UK bond investors and the outlook is only getting tougher, with the short end of the gilt market worried about stronger growth and asset price inflation and the long end under severe downward pressure due to the projected lack of supply of long-dated bonds
Last year there was a strong move into bonds as the Bank of England's Monetary Policy Committee (MPC) instigated a series of overdue interest rate cuts, reaching a low of 5%. But evidence of economic recovery has reignited fears about inflation and the MPC has turned rapidly more hawkish
It decided not to act at its October meeting but a 25 basis point rise is generally expected in November. UK growth is seen rising from 2% this year to around 2.5% next year. According to the RPIX indicator, which excludes mortgages, inflation should remain below the Bank of England's target of 2.5
But UK bulls say that unlike previous inflationary spirals, firms are simply not able to pass on increased costs to the consumer because customers will not accept it. Competition will keep a lid in the equity market and on inflation. "We believe that the pace and timing of interest rate increases will be less aggressive than the market is currently discounting," said Watson. "Although a lot of bad news is already priced in, gilt prices will continue to come under some modest upwards pressure as further evidence of economic recovery emerges. We expect yields to move slightly higher across the curve
The market has been discounting short term rates of 7.2% by the end of 2000. Many fund managers say that looks overly pessimistic given the path of growth and inflation
Richard Buxton, institutional and mutual group director at Baring Asset Management, says: "Bond markets have been spooked by the resumption of growth." He believes the traditional inflation indicators may be less useful now than they have been. "It seems growth is now no guarantor of inflation, and may be the reverse
Issues in the domestic market have been complicated by the question of when Britain might join the European single currency. Further along the yield curve, the prospect of Euro convergence becomes a factor. The Government received a setback in May when it fared poorly in the European elections and spreads widened in the swaps market as investors betting on UK convergence with Europe had to unwind their positions
The gilt market has also suffered form the explosion of the European corporate bond market. Some £30bn has been brought to the market so far as companies seek to raise money before the usual year end lull and also the date. "Also, the market is no longer expecting an actual recession or a credit crunch, which would affect corporate issuers, so corporate bonds begin to look very attractive again," noted one fund manager
Standard and Poor's Fund Research notes that through 1999 funds have increased exposure to second tier bond markets and embryonic high yield markets. "Managers are also looking more closely at strategic factors such as portfolio duration, credit spreads, yield curve positioning and trading strategies," a report said. David Dyer at AXA Sun Life Investment management says five year yields at over 6% offer good value, as they stand 40 basis points below equivalent euro rates
Ten-year gilt yields have been pulled down by the extreme imbalance at the long end of the market. The surge in demand has been attributed partly to the Minimum Funding Requirement (MFR), the provision introduced after the pension scandals of the 1980s. At the same time, the UK government is striving to attain a fiscally balanced budget, where it does not have to incur more debt through long term bond issuance
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