On London

April 1, 2011 8:27 pm

Faltering UK recovery gives gilts bull run extra impetus

April is a bad month for gilts. The government bond markets have tended to perform worse in April than in any other month since 1989.

This is because it is the first month in the financial year when issuance is at its heaviest, typically pushing bond yields higher.

But this month might see a break in the trend as many strategists predict gilts will continue to shine. With the exception of Spain’s, gilts were the best performing government bond market among the major European economies in March.

The obvious reason for gilts’ appeal is the weakness of the UK economy. This week saw poor money supply data, fragile confidence indicators and a warning from Sir Philip Green, the billionaire retailer, that high street sales were slowing down.

The markets are also pushing back expectations of interest rate rises. Just over a month ago, markets were pricing in the first quarter of a percentage point increase in May. On Friday, the overnight index swap markets, the best guide, had pushed this expectation back to July.

Yet the 42 per cent increase in gilts supply over the next three months (gilts issuance for the second quarter is forecast at £44bn compared with £31bn in the first quarter) will weigh on the market. Even the most bullish fixed income strategists expect gilt yield spreads over Germany, currently the narrowest for 18 months, to widen a little.

Benchmark 10-year gilt yields, which have an inverse relationship with prices, have also jumped a quarter of a percentage point to 3.72 per cent since the middle of March as confidence in the global economy has recovered, encouraging investors to switch out of fixed income and into equities.

The UK economy may be weak, but few analysts are predicting a slowdown or double-dip recession, which would lead to stronger demand for gilts. The market expects the economy, which saw a reverse in the fourth quarter last year, to return to growth in the first quarter when figures are published at the end of the month. With inflation running at 4.4 per cent – more than twice the Bank of England’s target – a strong argument can therefore be made against investing in gilts.

But for investors that want some exposure to the safety of fixed income, gilts still look a good bet as fiscal austerity measures bite deeper and wage pressures remain subdued.

The faltering recovery on the high street, amid a profit warning from Dixons, the electrical group, and a sharp drop-off in sales this week at J Sainsbury, the supermarket chain, adds to the appeal of government debt.

Also, demand from pension funds, insurance companies and commercial banks is unlikely to abate. Pension funds and insurers have to buy a certain amount of gilts, whatever the economic conditions. The recent rise in equities, however, has boosted their appetite for bonds because of the opportunity it provides to lock in profits in the safety of fixed income.

Demand from banks is unlikely to ease either, as new global rules on funding pressure them to buy liquid, safe assets. This demand is expected to increase further as banks must start returning short-term Treasury bills to the Bank of England as part of the winding-down of the special liquidity scheme, set up at the height of the financial crisis, early next year.

The banks will need to replace these Treasury bills, which they were allowed to exchange for harder-to-trade mortgage-related securities as part of the central bank’s effort to unstick the markets, with other liquid assets, such as gilts. Moreover, figures from the Bank this week showed international investors are still buying record amounts of UK government bonds. With worries persisting over the eurozone and the European Central Bank set to raise interest rates next week, gilts are unlikely to lose their attraction for the big sovereign wealth funds in Asia and the Middle East.

The gilts bull run, which many analysts date back to May 1997, when 10-year yields peaked at more than 7 per cent, may last a while longer.

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