Our views

Gilt corner: Forgive me chancellor, for I have sinned


Craig Inches, Head of Short Rates and Cash

11 December 2017

This week sees a flurry of UK data, with what we earn, how much of it we spend and how much it all costs once again under the microscope. Of these, the one which we’re watching most closely as bond investors will be inflation, currently forecast to maintain its plateau at 3% for a third month running.
If it ticks any higher than this, Mark Carney will be forced to write a strongly worded note to Philip Hammond, explaining the reasons for this overshoot. While you’d like to think that the chancellor actually has at least half an understanding of why inflation sits where it’s sitting already, the contents of the letter could actually be a useful signal to the market about the Bank’s plans for the path of rates in the near future. 
Saving Mr. Carney from the pen and inkwell could be sterling, which has appreciated steadily higher since the beginning of November. While part of it (like everything else in the UK right now) is Brexit related, some of this is down to the interest rate rise in November, bolstering the currency back towards $1.35 for every £1.
The rate of inflation will also be crucial on Wednesday when the latest labour market data is released. While real wage growth still looks likely to sit in negative territory, the consensus here is at 2.5%, a big increase on last month. Delivering positive real wages has frustrated many economies as monetary policy has tightened, though in the US after another month of solid payroll numbers and a dip in inflation to 2%, American pay packets are finally growing in real terms. Expect a poorly capitalised tweet on this soon. The other big American news of the week will be an interest rate hike that’s all but certain, the country’s fifth in the past couple of years.
With the last government bond supply coming this week before the Debt Management Office (DMO) shuts up shop for the winter, it’s worth noting that last week’s 30 year gilt auction was relatively lowly bid for, particularly given the time of year. While Christmas shopping might not seem a common trait for institutional pension funds, often large schemes with reporting periods ending in December tend to have an appetite to buy longer duration assets in particular index linked.  
Against this backdrop, the relative lack of demand for long-dated paper perhaps suggests that investors are more mindful than usual about the possibility of gilt yields ticking higher. However, at the short end of the curve, yields remain stubbornly compressed, with the spread between 2 and 5 year government bonds back towards its lowest level since the crisis. 
We don’t think this flatness in the curve and lack of term premium for these bonds stands up to scrutiny, and so we’ve gone underweight 5 year bonds in our funds, swapping them into shorter and longer dated assets offering better value. Elsewhere in our portfolios we’ve been trading the range, buying on the weakness caused by positive Brexit comments and selling any strength on unsettling geopolitical news. 
With market liquidity beginning to run a little dry as we approach year end, there may be some inefficiencies available to exploit in this regard as well, offering us a slightly early Christmas present!

This week sees a flurry of UK data, with what we earn, how much of it we spend and how much it all costs once again under the microscope. Of these, the one which we’re watching most closely as bond investors will be inflation, currently forecast to maintain its plateau at 3% for a third month running.

If it ticks any higher than this, Mark Carney will be forced to write a strongly worded note to Philip Hammond, explaining the reasons for this overshoot. While you’d like to think that the chancellor actually has at least half an understanding of why inflation sits where it’s sitting already, the contents of the letter could actually be a useful signal to the market about the Bank’s plans for the path of rates in the near future. 

Saving Mr. Carney from the pen and inkwell could be sterling, which has appreciated steadily higher since the beginning of November. While part of it (like everything else in the UK right now) is Brexit related, some of this is down to the interest rate rise in November, bolstering the currency back towards $1.35 for every £1.

The rate of inflation will also be crucial on Wednesday when the latest labour market data is released. While real wage growth still looks likely to sit in negative territory, the consensus here is at 2.5%, a big increase on last month. Delivering positive real wages has frustrated many economies as monetary policy has tightened, though in the US after another month of solid payroll numbers and a dip in inflation to 2%, American pay packets are finally growing in real terms. Expect a poorly capitalised tweet on this soon. The other big American news of the week will be an interest rate hike that’s all but certain, the country’s fifth in the past couple of years.

With the last government bond supply coming this week before the Debt Management Office (DMO) shuts up shop for the winter, it’s worth noting that last week’s 30 year gilt auction was relatively lowly bid for, particularly given the time of year. While Christmas shopping might not seem a common trait for institutional pension funds, often large schemes with reporting periods ending in December tend to have an appetite to buy longer duration assets in particular index linked.  

Against this backdrop, the relative lack of demand for long-dated paper perhaps suggests that investors are more mindful than usual about the possibility of gilt yields ticking higher. However, at the short end of the curve, yields remain stubbornly compressed, with the spread between 2 and 5 year government bonds back towards its lowest level since the crisis. 

We don’t think this flatness in the curve and lack of term premium for these bonds stands up to scrutiny, and so we’ve gone underweight 5 year bonds in our funds, swapping them into shorter and longer dated assets offering better value. Elsewhere in our portfolios we’ve been trading the range, buying on the weakness caused by positive Brexit comments and selling any strength on unsettling geopolitical news. 

With market liquidity beginning to run a little dry as we approach year end, there may be some inefficiencies available to exploit in this regard as well, offering us a slightly early Christmas present!

Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.