Of the major world economies, the UK is closest to reaching a peak in short term interest rates. Ag...
Of the major world economies, the UK is closest to reaching a peak in short term interest rates. Against the backdrop of a very positive Government supply story and an inflation rate well below the 2.5% target, Britannic believes that the outlook for gilts is very encouraging.
Economic activity in the UK looks to be moderating. Areas of potential overheating such as domestic demand and the housing market are now coming back to levels that are unlikely to cause concern for the Monetary Policy Committee (MPC). The biggest sources of inflationary risks, namely the housing market and the level of average earnings, currently appear to be much better behaved.
Some risks remain such as the rise of the oil price and the potential for Sterling to decline from current levels. However, on balance the risks are modest. We suspect that there may be another 0.25% to come from the MPC, but to all intents and purposes the UK is at the peak in short rates for the current economic cycle.
The fiscal situation in the UK is also a major positive for the UK Government bond market. We can expect no more than £7bn of new stock, including up to £3bn of index linked stock, between now and the end of this financial year.
Compare this with the £21.5bn of coupon and redemption money between now and 1 January 2001 and you can see that the supply/demand imbalance is very definitely in favour of gilts retaining a strong bid in the months to come.
But what about relative value? When comparing gilts with European bonds, gilts look historically expensive. But we are unperturbed at gilt yields falling below German bund yields as, on a harmonised basis, UK inflation is currently running at 0.5% year on year against something closer to 2.0% year on year in Europe.
Given our relaxed view of economic growth in the UK going forward, we do not envisage much erosion of this relative value in favour of gilts. In addition, although the fiscal situation in Europe is improving, it still has some way to go to emulate that of the UK.
In the US, however, we are unable to argue against a better supply story. This said, there is an obvious risk that the tightening cycle in the US economy is not yet complete.
Despite last month's very bond friendly economic data, we believe it is too early to commit to the view that economic growth and, in particular, domestic demand have slowed sufficiently to stay the Fed's hand.
Inflation risks remain most evident in the labour market and we are unsure that the US can continue to maintain the current level of growth and productivity gains to offset those risks.
Joe McKenna is the head of fixed interest at Britannic Asset Management
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