Bank of England crimps investors’ rate expectations

Investors’ waning expectations of future rises in interest rates are giving a lift to the UK government bond market.

Gilt yields dipped – meaning prices rose – after the Bank of England last week pulled back on its rate-rise plans, echoing more dovish noises from the US Federal Reserve. The BoE downgraded its economic outlook to its lowest level since the financial crisis a decade ago amid mounting uncertainty over Britain’s exit from the EU.

This week’s House of Commons debate on Brexit is unlikely to resolve the question of what form the UK’s departure from the bloc will take, with a vote having been pushed back to later this month. But it should shine a spotlight on the nation’s fractured political scene, fuelling investors’ jitters.

Last week BoE governor Mark Carney warned that the risk of a no-deal exit was rising. 

Mr Carney has in the past said that such a scenario could result in interest-rate increases – a move that should push up yields. But the downward move in gilt yields suggests that investors remain convinced a fresh bout of bond-buying stimulus is more likely than a rate increase.

As the prospect of rate rises fades, the additional yield that gilts offer over other major bond markets has helped to lure overseas investors back into the market.

Nearly four-fifths of the gilts in circulation are held by UK investors and the market has become increasingly reliant on domestic support. Last year foreign investors’ net purchasing of gilts hit its lowest level for more than three years.

That trend has now begun to reverse. In the 12 months to end-2018 overseas buyers increased their holdings of UK government bonds by a net £22bn, up from just £3.6bn in the 12 months to mid-2018.

Ten-year gilts offer a 1.06 percentage point yield premium to the equivalent German Bund, and a 1.24ppt premium to Japanese government bonds, which recently slipped back into negative territory.

Of the world’s major sovereign bond markets, only the US is priced well above gilts, making the spread unattractive for US-based investors. The 10-year US Treasury bond yields 1.46 percentage points more than the equivalent gilt.