When forecasting the future for UK bonds, the usual starting point is the outlook for the economy an...
When forecasting the future for UK bonds, the usual starting point is the outlook for the economy and the prospect for inflation.
However, there are now a large number of technical factors that will have a distorting effect on the market.
Given the relative openness of the UK economy and sterling's recent volatility, any current analysis has to take into account the level of the currency. During 1999, the UK benefited from a pick-up in world trade and this was reflected in strong export growth.
Hence much of the adverse economic impact of sterling's strength was obscured.
However, the effects are now being felt, as can be seen from both official data and survey evidence. Although the growth of the service sector still stands above trend, there are signs it may be peaking. Retail sales fell in April.
Turnover and pricing data shows that the housing sector may at last be cooling down. It will take further falls in sterling for significant tightening by the MPC.
The strength of the economy and the associated buoyant tax receipts means the Debt Management Office (DMO) has had to cope with a lack of required gilt issuance.
When this situation last occurred in the 1980s, official policy was to encourage long-dated rates to fall.
It was thought desirable to reduce the rates payable by corporate borrowers while the Government aimed to repay the National Debt. Now, with gilt supply insufficient to meet institutional demand and the consequent low level of annuity rates, the issue is not quite so one-sided.
As a result, the DMO has concentrated on maintaining issuance at the long end as well as buying back less liquid shorter-dated issues.
This has been exacerbated by the high receipts from the third generation mobile phone auction.
A more seasonal factor is that recent issuance has concentrated on building up benchmark issuance with identical payment dates in order to aid development of the gilt strip market. As a result, a large proportion of gilt income is received in early June and December each year Much of the reason for the downward sloping yield curve has been the Minimum Funding Requirement (MFR).
With the MFR currently effectively setting a gilt benchmark, trustees have been reluctant to diversify. Look for the benchmark to be loosened to include AAA and AA rated non-government issues. This should lead to a narrowing of spreads of such issues. The possibility of including non-sterling bonds in the MFR calculation seems less likely but cannot be ruled out.
David Dyer is an investment manager for AXA Investment Managers UK
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