UK government debt has delivered the worst returns of any major bond market in the first half of this year, as investors bet that the Bank of England will have to increase interest rates to the highest level in a quarter of a century to tame high inflation.
An ICE Bank of America index of UK government bonds — known as gilts — has fallen by 3.7 per cent in the first half of 2023. Meanwhile, other big bond markets have delivered positive returns as inflation has eased and other central banks appear closer to the end of their cycle of rate rises.
“Gilts have been a huge outlier this year, it’s been a very sobering experience,” said Jim Cielinski, global head of fixed income at Janus Henderson Investors. “You are seeing more of the traditional cost push inflation where wage pressures continue to move higher and higher.”
The poor performance of gilts comes after investors had a major rethink about the outlook for UK interest rates, with wages and inflation data relentlessly exceeding market and economist expectations. UK headline inflation was 8.7 per cent for the year to the end of May, compared with 6.1 per cent in the eurozone and 4 per cent in the US.
Retail investors and fund managers have been snapping up gilts in recent months to lock in some of the highest yields available since the global financial crisis. Nevertheless, two-year gilt yields hit 5.31 per cent on Friday, the highest level since 2007. But investors looking for short-term gains may be facing painful paper losses.
Markets are now pricing in UK interest rates to rise from 5 per cent to a peak of about 6.25 per cent by the end of this year.
While traders also expect more rate increases in Europe and the US, the moves are less stark, with markets pricing in a likely two more 0.25 percentage point increases by the ECB this year, and one more by the Fed in July.
“UK inflation both headline and core has been much stickier than what the Bank of England or the market expected,” said Mohit Kumar, chief European financial economist at Jefferies, explaining why gilts had underperformed peers.
He added that Andrew Bailey, BoE governor, sounded “surprised” by the persistence of inflation when talking on a panel at an ECB conference in Sintra, Portugal, this week, and that he sounded “uncertain” that inflation would come down quickly enough for the BoE to stop raising rates.
Investors also note that the long-dated nature of the UK bond market and the large volume of debt being issued while the BoE has started selling gilts as part of its quantitative tightening programme have and will continue to weigh on performance.
“The inflation and supply combination means gilts are still not quite there yet in terms of being attractive on a global market,” said Jon Day, fixed income portfolio manager at Newton Investment Management. “For global investors I would still say there are better markets out there than gilts.”
Janus’s Cielinski said stagflationary fears are “noticeably higher” in the UK than in other markets, as the central bank feels like it has “no choice” but to keep clamping down on inflation, regardless of the pain that will be inflicted on large swaths of the economy.
“You need to be tough but by being too tough and killing the economy and making it weaker than every other global economy — that is not a victory and it will come at such a cost that you will win the battle on inflation and lose the war,” he said. “I do think that is what the gilt market is saying.”