Weak growth, falling inflation and low policy rates – good for gilts
UK gilts have been underpinned by a potent combination recently - the enhanced credibility of the government in restoring health to the public finances, increased risk aversion and evidence of a slowdown in growth. In an environment of weak inflationary pressures and low growth, we think this process has further to go, especially with the possibility of further quantitative easing from the Bank of England later in 2010 or in 2011.
In the short-term a revival of risk appetite could lead to a modest backup in yields. Still, we think it is not too late for those investors who have avoided longer-dated gilts because of the outside risk of a Greek-style fiscal crisis in the UK to extend their duration (i.e. increase exposure to longer-dated gilts) now that these tail risks have receded.
Since late April, UK bond yields have fallen sharply amid a flight to safety, confidence that the new UK government has the ability and will to tackle the budget deficit and increasing evidence that the UK and other advanced economies are moving into a weak-growth, low-inflation, low-interest-rate environment.
However, the yield curve remains close to record levels of steepness. This is because short-term interest rates had been cut to post-WW2 lows by the Bank of England in response to the credit crisis and are yet to return to more ‘normal’ levels. Although long-term interest rates are also extremely low by historical standards, they have not yet fallen as much as short-term rates have. The key question is whether record steepness in the yield curve is unwound by an increase in short-term interest rates, or whether instead long-term interest rates fall further.
Longer-dated gilt yields have room to fall
Over the next 12 months, we think that weak growth and inflation and increasing expectations for policy rates to stay low for a long time will dominate. This will lead longer-term gilt yields to fall further too. IAMGE
There is a close relationship between medium-term expectations for monetary policy and long-term interest rates. And the Bank of England will set short-term interest rates in large part on the basis of the medium-term outlook for inflation and, by implication, growth.
Deflationary pressures to increase
Given the enormous fiscal consolidation envisaged in June’s Emergency Budget, it seems likely that UK growth will remain well below its longer-term trend, or potential, rate in 2011 and 2012. This will increase the spare capacity in the economy and increase deflationary pressures.
Indeed, it is possible that the Bank of England (BoE) resumes quantitative easing as this deflationary threat intensifies. BoE Governor King stated in his June Mansion House speech that a reduction in the budget deficit should not be postponed and that if growth prospects were to weaken ‘the outlook for inflation would probably be lower and monetary policy could then respond.’
Risks to our view on gilts
There are essentially three areas of risk to our bullish view on gilts. 1 - Stubbornly high inflation leading to a rate increase by the Bank of England. 2 - Increased investor concerns around the UK government’s ability to service its debt. 3 - A revival in risk appetite, possibly combined with stronger-than-expected growth or reduced financial system concerns.
If inflation does not fall quickly over the next few months, the BoE may feel compelled to hike rates, which would probably lead to long-term interest rates rising a little too. However, any increase in policy rates is likely to be small, and in the event we think the Bank will be more likely to look through any temporary spike in inflation, as it has done until now.
Renewed investor concern over the UK government’s ability to keep the national debt on a sustainable footing could also lead to an increased risk premium attached to government debt. Although there are implementation risks, we think that the new coalition government has built up enough credibility with investors with its emergency budget to be given ‘the benefit of the doubt’ for some time.
In the short-term, the greatest risk to our bullish view on gilts is a revival in investor risk appetite, leading to less need for the safety of bonds and a shift back into equities and other risk assets. A possible trigger for stronger risk appetite could be convincing euro-zone bank stress tests at the end of July.
Conclusion
However, any revival in risk appetite is likely to be relatively short-lived. On a 12-month horizon, we think that the headwinds of fiscal consolidation and consumer deleveraging that the UK and global economies are facing will lead to an increasing threat of deflation and keep long-term interest rates extremely low.
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