March 28, 2017 / 11:24 AM / 4 months ago

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

5 Min Read

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

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.

A Reuters poll published last week suggested the 10-year gilt yield GB10YT=RR will rise to around 1.67 percent in a year's time from 1.175 percent now. But some strategists thought 2.0 percent or higher is likely. [US/INT]

One Bank of England policymaker, Kristin Forbes, voted to raise rates this month because of growing inflationary pressures and others said they were close to joining her -- although the majority view was to tolerate above-target inflation for now.

Britain isn't the only advanced economy where economic data and inflation numbers are prompting investors to reassess the monetary policy outlook. The European Central Bank has said its sense of urgency to prop up euro zone growth is over and money markets have started to factor in a rate rise in the bloc by year-end.

The U.S. Federal Reserve hiked rates on March 15 after a string of hawkish comments from officials that triggered a rapid turnaround in expectations for a move this month. But the inflation outlook for Britain looks particularly acute, with a rise in energy prices compounded by the pound's near-20 percent fall against the dollar since June's Brexit vote.

Last month consumer prices rose 2.3 percent year-on-year, faster than expected.

Vulnerable

Gilts are one of the only major bond markets globally to deliver positive returns this year.

Ten-year yields GB10YT=RR are down 7 basis points this year. That compares with a rise of almost 20 bps in German and Swiss yields, while U.S. and Japanese yields are little changed from where they ended 2016.

For some bond fund managers, Brexit risks and the uncertainty hanging over the economy remain a reason to hold onto gilts. Bonds often benefit from an environment where investors view economic growth prospects as weak.

"I do think they offer a good hedge to Brexit risks," said David Zahn, a portfolio manager who runs Franklin Templeton's European fixed income strategies, which total around 2 billion euros ($2.2 billion).

But some temporary factors that have supported gilt prices recently are likely to fade.

The BoE has completed its gilt purchases as part of its "sledgehammer" stimulus plan designed to counter the shock of June's Brexit vote.

Overseas central banks and sovereign wealth funds devoured gilts late last year to top up sterling portfolios battered in dollar terms by the pound's post-Brexit vote plunge, but BoE data for January hinted at a reversal of this trend.

Pension funds have also been big buyers of gilts recently.

Official data show gilt holdings by insurers and pension funds stood at about 28 percent of the total in the third quarter of 2016 - the highest proportion since the final quarter of 2011.

But such funds, which need a fixed income stream to match payouts, typically make extra purchases of gilts to invest unallocated funds ahead of the end of the British financial year in April.

"The BoE has finished buying and we're coming out of Q1 - which potentially means (pension fund) buying is set to tail off," said Societe Generale rates strategist Jason Simpson.

"This, to me, leaves long-dated gilts looking vulnerable".

Graphics by Nigel Stephenson and Alasdair Pal; Editing by Jeremy Gaunt

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