Bond investors are flagging a deteriorating outlook for the UK economy as the country negotiates Brexit, with fixed-income assets denominated in sterling extending this year’s outperformance during May.
Yields on sterling-denominated bonds have remained low, with those on the benchmark 10-year gilt this week dipping below 1 per cent, a level not seen since October. In contrast, yields on US and German government bonds have lagged behind the drop in gilt yields, reflecting expectations UK growth risks lagging behind big competitors.
Survey data published this week suggested that the buoyant economic sentiment of recent months might be aligning with official data, which have for some time been signalling a slowdown.
The UK bond market’s concern about the economy has translated into relative outperformance for investors. Gilts generated total returns of 0.75 per cent in May, compared with 0.53 per cent for US Treasuries and 0.54 per cent for euro area sovereign debt, according to Bloomberg Barclays indices.
A wider measure that includes sterling-denominated corporate and other bonds fared even better, generating a total return of 0.9 per cent in May against the US equivalent of 0.67 per cent and a euro area aggregate of just 0.44 per cent.
The gloom of bond investors has exceeded that of the currency market, where sterling has found a range just below $1.30 since UK Prime Minister Theresa May called a snap election in April.
“The currency markets look as if they are pricing in a relatively even set of economic outcomes, but the bond markets are skewed towards a gloomier economic outlook,” said Mike Amey, head of sterling portfolio management at asset manager Pimco.
The level of pessimism priced into bonds is “overdone”, he said. “So far the economy has weathered the uncertainty pretty well”.
Britain’s decision to leave the EU has added a political layer of uncertainty to the economic outlook, leaving bond investors anticipating that the Bank of England will have little room to manoeuvre over the next two years.
The two-year gilt — a measure of investors’ risk appetite in the run-up to Britain’s EU exit in March 2019 — has been drifting lower since the referendum, and has repeatedly dipped below 0.1 per cent since the start of the year. Yields move in the opposite direction to a bond’s price.
Kacper Brzezniak, a portfolio manager at Allianz, said the political uncertainty meant the BoE would be constrained in the actions it could take.
As a result, he said, “I don’t see them hiking interest rates during the Brexit negotiations, particularly if we see even weaker economic performance than we’re seeing now” and so “it is hard to see a catalyst that would see yields move much higher”.
Lefteris Farmakis, global macro strategist at UBS, warned that “Brexit risks remain acute, all the more so if they materialise during a cyclical downturn”.
Some investors anticipate particular scope for a further downward shift in gilt yields in the coming week as the general election enters its closing days. The opposition Labour party has been gaining on the Conservatives in the polls, and research by pollster YouGov on Wednesday suggested the possibility of a hung parliament.
A shock Labour win would “lead to higher yields” and “very volatile” prices for gilts, said Nomura analysts. Sterling would initially move lower on the shock result but could then climb as investors anticipated a softer Brexit outcome.