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UK government debt has experienced the lowest returns among major bond markets in the first half of the year. Investors believe that the Bank of England will need to raise interest rates to combat high inflation, potentially reaching the highest level in twenty-five years.
Compared to other bond markets, the ICE Bank of America index for UK government bonds, known as gilts, has declined by 3.7% during the first half of 2023. This is due to eased inflation and other central banks nearing the end of their rate hike cycles.
Jim Cielinski, Global Head of Fixed Income at Janus Henderson Investors, describes the performance of gilts this year as “a very sobering experience.” He attributes this to rising wage pressures, which contribute to more traditional cost-push inflation.
The decline in gilt performance is a result of investors reevaluating their expectations for UK interest rates. Wages and inflation data consistently surpass market and economist predictions. UK headline inflation stands at 8.7% for the year ending in May, while the eurozone’s is 6.1% and the US’s is 4%.
Retail investors and fund managers took advantage of the highest yields available since the global financial crisis by purchasing gilts in recent months. However, two-year gilt yields reached 5.31% on Friday, the highest level seen since 2007. Investors seeking short-term gains may face paper losses as a result.
Market forecasts suggest that UK interest rates will rise from 5% to approximately 6.25% by the end of the year. Europe and the US are also expected to see additional rate increases, albeit less significant, with the European Central Bank projected to raise rates by 0.25 percentage points twice more this year, and the Federal Reserve increasing rates once more in July.
Mohit Kumar, Chief European Financial Economist at Jefferies, attributes gilt underperformance to UK inflation persisting more than anticipated by the Bank of England and the market. He notes that Andrew Bailey, Governor of the Bank of England, seemed “surprised” by the ongoing inflation during a panel discussion at an ECB conference in Sintra, Portugal. Bailey expressed uncertainty about whether inflation would decrease quickly enough to halt further rate hikes.
Investors also point out the extended maturity of the UK bond market and the large volume of debt being issued while the Bank of England carries out its quantitative tightening program, which continues to weigh on gilt performance. Jon Day, Fixed Income Portfolio Manager at Newton Investment Management, states that gilts are not yet attractive on a global market due to the combination of inflation and supply.
According to Cielinski, the fear of stagflation is more pronounced in the UK compared to other markets. He suggests that the central bank feels compelled to continue combating inflation, regardless of the potential harm to the economy. He emphasizes that excessively harsh measures could weaken the UK economy compared to other global economies, resulting in a Pyrrhic victory of controlling inflation at a high cost.
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