Investors emboldened by the Bank of England’s unexpectedly dovish tilt this week are loading up on UK government bonds as anxiety over the inflation outlook begins to give way to concerns about economic growth.
Five-year gilts – among the most sensitive to changes in policy – posted their biggest two-day advance on Friday since Russia invaded Ukraine, leading gains across peers. BMO Global Asset Management says UK government bonds could continue to outperform Treasuries and German debt. For AllianceBernstein, which had bolstered its position in UK assets, the short end of the curve is attractive.
Policy makers surprised investors on Thursday by emphasising the risks that soaring energy prices pose to household incomes, prompting markets to dial back bets for aggressive interest-rate hikes this year. Prior to the decision, an unusually large 50-basis-point rate increase over the coming meetings was all but certain for the market, with expectations driving a selloff that pushed five-year yields to the highest since 2015 last month.
Now, with the impetus for an aggressive pace of tightening fading as Russia’s invasion of Ukraine adds to a gloomier growth picture, UK bonds appear to have found a backstop. That’s even as investors brace for inflation to accelerate over the coming months, and for the government on Wednesday to announce fresh gilt supply for the upcoming fiscal year.
“If things do turn nasty in terms of the growth outlook, then the five-year part of the curve could perform very nicely because it will respond well to the market pricing out those interest rate hikes it spent a long time pricing in,” said John Taylor, portfolio manager at AllianceBernstein.
The turnaround in sentiment shows how quickly the tide can turn if central banks pivot back to bolstering their economies. The shift is all the more impressive because the BoE was the first among major central banks to start raising interest rates this cycle.
The European Central Bank surprised investors with a faster exit from stimulus earlier this month despite being more exposed to the economic fallout of the Ukraine war. The Federal Reserve also matched market expectations for an aggressive tightening cycle this year in its so-called dot plot, which it uses to signal its outlook for the path of interest rates.
“Over the last six to eight months the BoE has definitely been viewed as in the vanguard when it comes to how much is being priced in,” said Chris Lupoli, a rates strategist at BNP Paribas. “It seems as if the hawkish mantle is perhaps handed over to the other side of the Atlantic.”
Money markets are pricing about 120 basis points of rate hikes from the BoE compared with 143 basis points on before its decision this week.
Since Wednesday’s close, the yield on five-year debt has plunged some 16 basis points. The bias toward shorter-dated debt also steepened the yield curve, with the spread between two and 10-year yields widening to around 30 basis points from less than 10 basis points a week ago.
This trend could continue, according to James Lindley, a portfolio manager at BMO Global Asset Management, as the BoE’s less aggressive stance on inflation prompts investors to re-consider holding longer-dated debt. Next week’s data could act as another reminder of soaring price growth, with headline inflation expected to accelerate to 6% in February, the highest since 1992.
The Debt Management Office is set to announce its gilt issuance plans for the upcoming fiscal year next week. The sales won’t be cushioned by BoE bond-buying, which ended in December, and could weigh on longer-dated debt versus shorter-dated, according to Aegon Asset Management portfolio manager James Lynch.
Still, bonds can still look attractive to investors who are concerned that central banks may have no easy way out of the combination of rising prices and slowing growth. Waiting too long to tighten policy risks fuelling inflation, while erring on the side of more hikes now is an added headwind to growth.
With yields having moved higher in recent months, it provides a “cushion” against the risk that central banks turn hawkish again, said AllianceBernstein’s Taylor.