Assessing the direction of UK gilt yields over the past five years has required a mixture of skil...
Assessing the direction of UK gilt yields over the past five years has required a mixture of skill, luck and innovation.
The latter attribute has been particularly important as subsequent regulatory and supply factors have driven UK bond yield levels adrift from normal economic fundamentals. UK bond fund managers have gradually acquired a skills set distinct from their international counterparts.
By way of examples, we include traditional measures that use the future predictive features of bond yields, effectively dismissing the theoretical notion that bond coupons are re-invested at the same yield level and therefore taking into account the shape of the interest rate curve.
Comparing this measure to its German government bond equivalent allows managers to put the premium on UK long gilt yields into context. While pension fund demand and liquidity has always carried a premium in the UK, we have seen squeezes to -220bp through bond yields during the tough regulatory environment of recent years.
Traditional yield curve relationships have broken down. Analysis of the historic correlation of this relationship requires this leakage to the swap market to be taken into account.
So, while many market pundits have been arguing that the inverted curve environment has changed and the UK yield curve should be positive throughout, this measure has been cautioning that swap market activity justifies the current premium on long yields.
Where do these and other tools of the trade leave us in assessing the UK gilt market? After years of regulatory distortion, exacerbated by the net repayment of government debt, the chancellor's 2002 Budget could be a pivotal moment in the supply/demand debate.
While nudging the trend level of growth higher, to 2.75% from 2.5%, has been generally frowned upon, the budget measures were perhaps more revealing in what they didn't contain. The focus on the NHS in the tax and spend equation begs the question: what about other domestic issues such as transport?
Conspiracy theorists can easily construct a case whereby the resolution of the Railtrack debacle has cleared the log-jam on City co-operation over PFI project financing. As such, there are some substantial numbers being suggested over the scale of this off-balance-sheet debt issuance ' the type of numbers that would seriously dent the rarity premium still evident in long gilts.
Demand for UK bonds remains solid with both the mark-to-market accounting regulation FRS17 having an influence and, most recently, solvency concerns for both pension schemes and Life companies being revisited because equity markets have wobbled.
Ultimately, though, the current urgency in the demand dynamics will fade and we will be back to an environment that is less than healthy for bonds. Loose monetary policy, buoyant consumers, minimal spare capacity in the economy and a rampant housing market will all require medicine in the form of higher interest rates.
Life company solvency.
FRS17 and end of defined benefit.
Inflation is below target.
Moves to overweight equities and fixed income
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