The gap between the UK and US 10-year government bond yield has been widening significantly since last year's Brexit vote. However, the FT's Miles Johnson argues that anyone betting against gilts should be cautious.
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The UK may have voted to leave the European Union, but will this mean that its government bond yields will be able to be unshackled from a different type of overseas influence? For several decades, ten-year UK gilt yield has so closely tracked the yield on US treasuries that in the words of the Bank of England's bank on the ground blog, anyone looking at an unmarked chart of the two would struggle to say which was which.
Over the last year, however, this intimate, transatlantic relationship had started to break down. With the spread between the UK and US 10-year government bond widening significantly since last year's Brexit vote. The gap currently sits at about 1 percentage point, having been as wide as 1.4 percentage points earlier this year, meaning that investors opting to hold equivalent US government debt being paid more over gilts than at any time in more than 20 years.
So there's this apparent rupture in a multi-decade trend in gilt yields, means investors will be able to profit by betting that the spread will snap back to normal. A number of hedge funds are already betting that gilt yields are heading higher. Based on the idea that Brexit will damage the British economy. Algebris, one of these funds, has argued that shorting gilts is a no brainer, because not only is the UK economy already vulnerable to shocks with a fiscal deficit of 2.8% of GDP, and public debt of 89% of GDP, but that gilt yields are also running way behind 10 year inflation expectations.
Other speculators are taking less of an explicit view on Brexit and instead are making a wider call that developed market bond yields will rise as part of a broader shift towards expansionary fiscal policy around the world. Yet anyone hoping the gap between US and UK yields offers a third compelling rationale for betting against gilts should be cautious.
If a sterling denominated investor today chose to buy a 10 year treasury for extra yield and then hedged this back into sterling, then at current prices, almost all of the additional return would be eaten up by that hedge. This means that trading the gap between US and British debt is merely a currency play rather than a clean bet on the longer term value of UK bonds. Gilt yields are likely to rise further, but trying to justify this trade based on the UK US gap closing is little more than a fancy money illusion.