With political risk showing no sign of abating in the wake of the UK’s vote to leave the European Union, gilt yields could move even lower in the coming months, argues Charlie Diebel.

 

Following the referendum on the UK’s membership of the EU on 23 June 2016, Charlie Diebel, Head of Rates, took part in a Q&A session on the prospects for gilts and other sovereign bond markets.

 

Do you think the UK’s credit rating downgrades will have any impact on demand for gilts? After all, treasuries rose after the US lost its AAA status in 2011 and the rise in gilt yields since the downgrades suggests the UK is still regarded as a safe haven?

No, I do not believe the downgrades specifically will affect investor appetite for gilts, since underlying macroeconomic conditions are usually the key driver of demand for any asset. However, the downgrades may alter the composition of demand. International reserve managers – largely foreign central banks – have been among the major buyers of gilts over the past 18 months or so. If they believe that sterling assets are less attractive and allocate away from sterling to euros, dollars or other reserve currencies, demand for gilts could drop. On the other hand, we could see a more supportive backdrop for gilts. Moreover, even though valuations might appear expensive, investors could favour gilts over corporate bonds and other asset classes.

Much depends on the terms of the deal the UK eventually strikes with the EU. However, the outcome remains some way in the future. The government has yet to trigger Article 50 and notify the EU of its intent to leave the organisation. That move cannot take place until a new prime minister is in place, which may not be until September. It is also unclear how long the negotiations will take. Article 50 supposedly triggers a two-year process but it could take much longer to reach an accord. We do not know how the political landscape will change over this period or the willingness of the remaining members of the EU to negotiate. In this environment political risk is key.

Do you think Brexit will have a significant impact on the public finances? Will the government need to issue more debt to finance any deterioration in the deficit and will it have difficulty selling it?

Over the next 18 months to two years we expect growth will be between 1.5 percentage points to 2 percentage points lower than would otherwise have been the case. The economy may not fall into recession but very weak growth is likely. As a result, the UK’s fiscal position will deteriorate.

The market should be able to absorb any rise in issuance as long as the economic background is supportive. Life insurers and pension funds account for much of the demand for ultra-long gilts and ironically these institutions may feel compelled to buy more bonds rather than fewer. There is certainly no reason to believe that a deterioration in the public accounts would force gilts yields higher.

Have you detected a change in foreign investors’ view of gilts? Is the fall in the currency helping to offset any concerns about the economy and political stability?

As previously mentioned, international reserve managers and the domestic life and pension fund industry have been the main buyers of gilts. They could allocate away from sterling, but international reserve managers tend to change their positions very slowly and any move would take years. In the near term, the demand profile for gilts will not change. Meanwhile, the domestic life insurance and pension fund industries have limited room for manoeuvre.

By boosting exports and dampening demand for imports the currency will act as an automatic stabiliser. However, unless the pound’s decline is much larger than we have seen to date, the impact of falling business confidence and investment on the economy will tend to outweigh the benefits of a cheaper currency. According to most current forecasts, sterling’s depreciation is likely to be of a magnitude that merely softens the impact of Brexit on the economy.   

Are you concerned that continental European institutional investors, who have a significant position in UK gilts, might sell, having made money as gilts rallied?

I do not believe that should be a concern at the moment, although the outcome of the negotiations on the UKs’ future relationship with the EU will be crucial in determining whether investors allocate away from sterling assets. In the short-term, investors might be inclined to stay with an asset class that is performing strongly.

Will inflation pick up following sterling’s decline and what impact will this have on demand for inflation-linked bonds?

Inflation will certainly accelerate. For example, petrol prices are bound to rise. Inflation-linked bonds have already responded strongly with break-evens leaping in anticipation of a spike in inflation. The question is how long will the jump in inflation persist? Given its adverse impact on aggregate demand, we anticipate Brexit may actually dampen inflation over the medium term.

Yields are very low but can they fall further given the outlook of political instability, a softening economy and interest rate cuts?

Yes. Clearly yields are at historically low levels but we are in an unprecedented situation. We do not know the extent of the damage to the economy or what the policy response will be.

Could we see negative yields on gilts in the next year?

Again, much depends on the policy response and the outlook for the economy. Further quantitative easing and a loosening of monetary policy would certainly help drive the currency lower, although there is some debate about the effectiveness of these policies. Negative yields certainly cannot be ruled out given that we are in an extraordinary situation.

Where do you see particular value in the market i.e., in terms of duration, etc.?

We like short-dated, inflation-linked products for the reasons described earlier and we are looking to build in a long duration bias, given the prospect of further monetary easing around the globe.

Does Brexit have any implications for sovereign bond markets elsewhere?

Most definitely, if only because of its adverse impact on global growth. Over the next two years, economic growth in Europe and around the world is likely to be around 50 basis points and 25 basis points lower respectively than would otherwise have been the case.

Factor in the political uncertainty and we believe the European Central Bank, the Bank of Japan and other Asian central banks could loosen policy. Similarly, the Federal Reserve is unlikely to tighten monetary policy further until well into 2017. That outlook should support the front end of yield curves.

Over the longer term we believe the UK economy will suffer and that political risk elsewhere will rise. An Italian referendum on constitutional reform is due in October. If prime minister Renzi loses the impact could be profound. His government would almost certainly fall, which could propel the Five Star Movement, which is calling for a referendum on Italy’s membership of the euro-zone, into power. We also have elections in the US in November and in France, Germany and the Netherlands next year. We expect this environment to be generally supportive for sovereign bond markets around the world. 

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