Like the rest of the world’s developed government bond markets, UK gilts have done pretty well out of the turmoil in stock markets. The yield curve has also steepened significantly, across the whole curve. The short end has benefited most as the market has re-assessed the outlook for short term interest rates. Peter Day, a gilt portfolio manager at Barclays Global Investors (BGI) believes that the short end of the market is correct to be attaching some probability to an interest rate cut by the Bank of England, but believes it is by no means certain the Monetary Policy Committee (MPC) will actually cut rates soon.
“The UK manufacturing sector is clearly struggling,” he says, “and there are tentative signs that consumer spending may be slowing down. However, with the housing market showing signs of overheating, the MPC will be cautious about cutting interest and further fuelling rises in house prices.”
Of course, another factor that has a huge bearing on the gilt market is the question of the UK joining European Monetary Union. “This is a key consideration for gilt investors, and the market fluctuates as opinion shifts between going in and staying out. Prime minister Blair is pro-Euro entry, but is watching the opinion polls on this one,” argues Day. “There are a lot of other matters occupying the government now, not least the potential war in the Gulf, and it is likely that any referendum will be delayed until the next parliament.”
Supply/demand dynamics are also interesting in the UK. After the recent announcement of Chancellor Brown’s spending plans for the future, the prospect of an increased supply of gilts became apparent. “Supply for the current fiscal year has been well sign-posted and should not be a surprise to the market,” comments Day. “But the underlying issue of greater government supply will doubtless resurface as we go into next year.”
On the other side of the equation, the demand picture is rather less clear. The UK gilt yield curve has long been distorted, and inverted, by the combination of limited supply and strong institutional demand for long-dated gilts by UK life insurers and pension funds.
UK life insurers have increased their UK bond exposure, at the expense of equities, as the additional yield has helped to boost insurers solvency ratios. After the equity market falls of July and August, however, some are beginning to question whether this switch still makes sense. According to a recent report from Morgan Stanley, a further 10% fall in equities would see them offering a higher yield than gilts, using the life insurers’ method of calculating equity yields as the average of the dividend and earnings yields. The Morgan Stanley analysts then go on to question whether this strategic equity-to-bond switch remains valid.
But Day points out that many pension funds have also undertaken the shift from equities into bonds. “The increased allocation to bonds by UK pension funds has often been undertaken in order to match future liabilities more closely rather than motivated by a tactical view of equity market valuations. Equities have become more attractive on a relative valuation versus bonds, but I don’t see this necessarily inducing large scale shifts out of bonds.”
Day goes on to suggest that in the short term, gilt market returns may be driven by other, more technical factors. “A large proportion of gilts pay out coupons at the start of December, and these monies are usually invested straight back into the market. Further, various gilt-based investors tend to take off or reduce non-benchmark bets and return money back into gilts to square their books before year end,” states Day. “For these reasons UK gilts have traditionally outperformed other government bond markets over the final three months of the year.”