UK gilts buffeted by global bond selling

Post-election exuberance in the UK's gilt market lasted barely a day. In spite of a rally in sterling this week, prices for UK government debt have fallen as investors sour on long-dated global bonds.

Just a week ago, it was all looking different. Investors in fixed income celebrated a Conservative party's election victory that was dubbed the most unpredictable in memory.

The majority for a party promising fiscal prudence boosted gilt prices and pulled the benchmark 10-year yield briefly below 1.90 per cent.

Broader influences, notably rising oil prices, have prevailed since, at one stage sending 10-year yields back over 2 per cent on Thursday, a level last seen at the start of December.

"What's happening in gilts has nothing to do with domestic forces," says David Owen, chief European financial economist at Jefferies. "This is all being driven by a sell-off in European bonds, possibly on the back of rising oil prices and an inflation pick-up."

Rising inflation expectations tend to deter investors from bonds because the value of their fixed income payments looks less attractive over time. Inflation expectations have been rising as investors anticipate that the European Central Bank's quantitative easing policy will succeed in pushing consumer prices higher.

In Germany's bond market, the benchmark for wider European markets, prices have been swinging.

At the inception of the ECB's bond-buying programme in March, prices jumped, sending yields down. As banks cautioned that the ECB's demand could exceed supply, yields on 10-year Bunds dropped to a record low of 0.05 per cent. They have since climbed to 0.70 per cent and market gyrations exacerbated by poor liquidity show little sign of letting up.

"Gilts are being moved by bonds in Germany," says Joakim Tiberg, strategist at UBS. "They were pushed down to record lows when German 10-year yields were heading towards zero. Now they are being pushed up as German bonds sell off. Domestic issues will come on radar screens at some point but not yet."

Domestic issues that loom for investors include the Tories' pledge to allow the UK to vote on its future in Europe and the success of the Scottish Nationalists, which has raised fears of a split in the UK.

Credit rating agency Moody's noted that the SNP's victory was fuelling speculation that their strong showing would lead to a second referendum on Scottish independence, despite a No vote last year.

Even if Scottish independence rears its head again, investors pointed out at last year's referendum that Scotland accounted for less than a 10th of the UK economy and that a sell-off in gilts was not a necessary outcome of a Yes vote.

Ahead of September's independence vote, gilt markets were relatively calm. The only obvious fallout registered in Spanish markets, where prices fell amid worries about implications for the Catalan secession movement.

Instead investors are watching for signs that the Bank of England might be one of the first central banks to raise interest rates.

On Wednesday the BoE downgraded the UK's growth forecast and said inflation would stay close to zero for much of the year, suggesting that interest rates were likely to rise in 2016 at a slow and steady pace. The neutral tone helped to shield gilts from a heavier sell-off across eurozone bonds on Wednesday.

"After the election 'relief rally', gilts are now being carried more on a tide of international rather than domestic forces," says Neil Williams, chief economist at Hermes Asset Management. "One of those is the reality check that falling consumer prices in the US and UK have been oil inspired, not structural. The other is that the ECB's QE is doing the trick."

However, international investor appetite for gilts could be buoyed by their high yields compared with those of the eurozone, where the central bank is buying bonds that yield anything above minus 0.2 per cent.

"Minus 0.2 per cent yield remains an important line in the sand for all bond markets," says Mr Williams. "The grab for yield will continue, and UK gilts and US Treasuries offering significantly more than this will at some stage again look attractive."

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