British bonds buoyed by Brexit risks, but prone to inflation burn

Tue Mar 28, 2017 7:21am EDT
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By Dhara Ranasinghe and Andy Bruce

LONDON (Reuters) - Fast-rising inflation and growing talk of tighter monetary policy from the Bank of England may spell the end of a winning streak for British gilts, among the best performers in major government bond markets this year.

Yields on 20- GB20YT=RR and 30-year gilts GB30YT=RR neared five-month lows on Monday, contrasting with short-dated yields which last week notched up their biggest one-week rise since early January as inflation sailed past the BoE's 2 percent target.

Such low yields -- resulting from bond price rises -- for long-dated paper in part reflect doubt about how Britain's economy will perform after the country leaves the European Union and therefore the ultimate outlook for inflation and interest rates.

Only Japan, still struggling to generate sustained inflation, has a flatter yield curve than Britain's among major economies. Britain's yield curve is at its flattest since October, with the gap between two- and 30-year gilt yields standing at around just 157 basis points.

But many strategists think the inflation burn is being underestimated and that yields will rise. Real or inflation adjusted long-term yields, assuming the BoE meets its 2 percent target over that time, are negative out to 50 years.

The latest Reuters poll of economists predicts consumer price inflation will near 3 percent late this year -- but previous bouts of high inflation in 2008 and 2011 suggest this may be a conservative estimate.

"The gilts market is the biggest (yield) steepening trade we could bet on right now," Kevin Gaynor, head of international research at Nomura, told a fixed income roundtable earlier this month. "The inflation picture is going to be much worse than expected."

Rising inflation is usually bad news for bonds, which fall in value as interest rates rise.   Continued...

FILE PHOTO: City workers walk past the Bank of England in the City of London, Britain, March 29, 2016.  REUTERS/Toby Melville/File Photo