Gilts look set to underperform global bond benchmarks going forward, with the short end of the marke...
Gilts look set to underperform global bond benchmarks going forward, with the short end of the market having overshot the most likely path of base rates.
If global bond yields do not fall significantly, gilts are also likely to underperform cash and, if further signs emerge that global growth is troughing, equities as well, according to Michael Saunders, analyst at Salomon Smith Barney.
Saunders believes the short end could be over-discounting global risks to growth. "Two-year yields are 30bps-40bps below the consensus forecast for the average level of three-month rates at the end of this year and the next," he says. "By contrast, on average over the past 10 years, two-year yields have been 30bps above the consensus on three-month rates."
UK notes may perform worse than bonds in the days ahead, amid reports that growth is not waning enough for the Bank of England to lower interest rates as much as expected.
Only reports showing even slower growth would push notes further because the market has already priced in a reduction of 50 basis points from the current rate, Saunders says.
Yields on two-year UK Government bonds also fell below those on 10-year bonds for the first time since September 1997 recently. The premium investors now seek to buy 10-year bonds at about eight basis points. That was after Fed unexpectedly cut interest rates by half a per cent, spurring expectations that the UK central bank might follow suit, he adds.
Saunders believes interest rates are unlikely to fall as far as markets project. "With low near-term inflation and modest growth, the MPC will probably stay biased to ease near term and cut by 25bps in the next two months," he says. "Rates may fall by a further 25bps in the third quarter if the global backdrop stays weak. However, if equities rebound significantly, or external business and consumer surveys improve, then the case for that second 25bps cut will fade. Either way we doubt that the MPC will ease as far as the markets price in unless the global backdrop worsens markedly."
Global risks to growth are discounted in the UK short end to a much higher extent than other markets, according to Saunders. He says: "For example, US two-year yields are about 40bps above the 1998-1999 low, even though US business and consumer confidence are well below the 1998-1999 lows. In our view it makes little sense for these global risks to be priced in to a greater extent in the UK than in the US."
Even with external shocks, UK growth is unlikely to slip significantly below trend on a sustained basis, unless the global backdrop is very weak. Fiscal policy is loosening sharply, money and credit are buoyant and the recent gains in mortgage commitments and unused credit facilities imply that credit availability remains very easy.
Saunders believes the drying-up of demand for gilts from UK life and pension funds should cause the long end of the curve to disinvert further. "The gap between gilt issuance and life and pension funds transactions has fallen sharply and the scarcity premium on gilts has fallen, causing the long end to disinvert markedly," he says.
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