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Last updated: November 8, 2012 8:53 pm
The great gilt rally is showing signs of fatigue. After plunging to the lowest level since records began in 1703, the UK government’s benchmark borrowing costs have edged up noticeably since the summer.
This is partly because of the fact that Europe looks like a less dangerous place to invest after the European Central Bank promised to do “whatever it takes” to save the euro, crimping demand for havens. But gilts have markedly underperformed US Treasuries, German Bunds and Japanese government bonds since then too.
Rather, the main cause for the lacklustre performance of gilts is the dimming expectations of quantitative easing from the Bank of England.
Just a few months ago, another £50bn of bond-buying was widely expected to be announced at Thursday’s Monetary Policy Committee meeting, bringing the total up to £425bn. Instead, the MPC kept its electronic money printing press on hold.
Gilt yields edged up once the decision was announced, but the lack of QE was largely priced into markets, investors and analysts say.
In the run-up to the November meeting, various MPC members had suggested there was no need for more gilt purchases, culminating in a speech by Sir Mervyn King, governor of the BoE, warning that the central bank “would think long and hard before it decides whether or not to make further asset purchases”.
Although yields are still extraordinarily low in a historical context – the current 10-year yield of 1.78 per cent compares with an average of 4 per cent over the past decade – many investors and analysts say they are likely to continue to climb higher.
“With the Bank no longer sponging up supply ahead of auctions, we’ll get a soggier, heavier market going forward,” says John Wraith, a strategist at Bank of America Merrill Lynch. “We won’t see a capitulation, but a slow move upwards in yields.”
The longer-dated gilts are at the most risk from the shelving of the BoE’s QE programme. The recent weakness has been more pronounced in bonds maturing in 30 years and beyond, and many investors and analysts expect this to continue.
“There’s some reticence to invest, particularly in the longer end of the curve,” says Miles Tym, institutional gilts fund manager at M&G Investments. “It’s quite a steep curve now.”
Not everyone is prepared to call the death of QE in the UK and the end of the gilt rally. Recent data has nurtured hopes that the UK economy has started a tentative recovery, but many analysts are unconvinced.
“The economy has been zigzagging, and the zag from the Olympics has encouraged too much optimism,” says Neil Williams, chief economist at Hermes Fund Managers. “We don’t think it is RIP for QE.”
He expects another round of bond-buying early next year, and points out that UK bonds could also benefit from another bout of turmoil in Europe. “Gilts and the pound are still a safe haven for many investors.”
Yet most analysts and fund managers expect another unconventional monetary policy tool is likely to play a bigger role in the future – the Funding for Lending Scheme launched by the BoE and the government.
The FLS aims to improve the flow of credit to businesses and households by offering cheap Bank of England funding to participating banks in return for lending. While Mr King and the rest of the MPC appear to have lost faith in the ability of “conventional” QE to resuscitate the economy, they have high hopes for the FLS.
Banking analysts, however, are more sceptical of the efficacy of the scheme. “The quantum of money is a drop in the ocean,” says Rob James, pan-European financials analyst at Aviva Investors.
He says FLS fails to address the real reason why banks are not lending enough: solid companies do not want to borrow money, and the ones that do are not necessarily creditworthy. Moreover, new regulations encourage banks to hoard capital, not lend.
If FLS disappoints then the BoE could quickly revisit its blunter, original policy tool, predicts Mr Wraith: “As long as the economy remains this weak then QE will never be far away.”
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