Confirmed pick-up in growth for the world economy has fostered nervousness in fixed income bond mark...
Confirmed pick-up in growth for the world economy has fostered nervousness in fixed income bond markets.
Performances for the last three months across national boundaries during the period have thus been disparate with positive outcomes for the US with 1.09% and 0.52% for Japan and negative performances for the euro zone with -0.23%. The gilt market was flat.
Over the last few months, the gilt curve has been inverting. The beginning of the inversion has moved from the five-year, six months ago to the two-year today. This is due to increases in the base rate and the market's view that increases may stall in the coming months and the curve will inverse itself in the coming couple of years.
The strength in the pound, the slowing of the industrial sector and the anticipation of benign inflation by the Bank of England has contributed to the performance of the short end of the UK yield curve.
In the short end we believe that the current expectation for rate hikes in the coming year (about 100bp) is unjustified. The strong pound, the downward trend of retail inflation (currently under the BOE's target), the downward trend in average earnings and the widening of swap spreads will cap the current anticipation and even bring them lower. This suggests there is value at the short end of the curve.
We continue to be prudent on the longer part of the yield curve as it is driven by structural factors. The strength in economic activity will only contribute further to this situation as budget surpluses increase at a higher rate than anticipated. The continued trend in inversion of this part of the curve (a 10 to 30 year spread of -90bp) is due to three factors. UK life insurers have for some time had asset/liability mismatch on their life guaranteed annuity products. Life insurers sold life annuities offering yields in excess of what is currently available and to compensate, insurers have invested heavily in long maturity gilts. Pension funds are also matching their long term liabilities with long gilts.
But at the same time, under the government's minimum funding requirement, long government bonds cannot be freely issued. The UK government's budget surplus limits the amount of issuance in bonds.
Finally, life insurers were covering their asset/liability mismatch by using structured products, but the recent blow out in swap spreads has increased volatility in such instruments making them more expensive and thus less attractive. Insurers have consequently resorted to covering their liabilities with long maturity gilts.
Although this inversion of the long end should resolve itself in the medium to long run, in the near term it is likely to continue.
We do expect the yield curve to reshape itself into a more conventional form. Short-end paper is likely to reflect benign inflation before resuming more pronounced anticipation in rate increases, whilst longer paper will live a life of its own for the near future with little regard to fundamentals.
Laurent Hirsch is fund manager at Framlington
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