UK short-dated bonds led a broad gilt market rally on Wednesday, as signs of easing inflation encouraged the view that the Bank of England is nearly done with raising interest rates.
(Bloomberg) — UK short-dated bonds led a broad gilt market rally on Wednesday, as signs of easing inflation encouraged the view that the Bank of England is nearly done with raising interest rates.
The yield on two-year gilts, among the maturities most sensitive to the outlook for interest rates, fell as much as 15 basis points to 3.65%. The UK yield curve bull-steepened, as 10-year borrowing costs slipped less than short-dated peers.
Data on Wednesday showed Britain’s inflation rate slowed for a third month, causing traders to pare their bets for further BOE rate hikes. The wager now is for rates to rise to 4.53% in September, lower than the 4.69% predicted on Tuesday.
“The CPI report supports the view for the BOE to step down its pace of rate hikes and also end its hiking cycle soon,” said Pooja Kumra, a rates strategist at Toronto-Dominion Bank.
Gilts still have room to rally, according to Kumra, who sees shorter-dated UK bonds outperforming peers, given the BOE may end its tightening cycle earlier than the US Federal Reserve or European Central Bank. Market wagers on the BOE’s peak rate could be trimmed to as low as 4.3%, she reckons.
Ten-year yields dropped 12 basis points to 3.40%, pulling away from Tuesday’s one-month high.
Since the BOE’s last rate decision on Feb. 2, the 10-year rate has risen by roughly 40 basis points, in line with the repricing seen across global bond markets this month, as traders respond to signs of a more resilient US economy and a sticky inflation picture. Kumra attributes that gilt move to investors closing long positions, rather than initiating new trades.
Gilts have whipsawed this week, with two-year yields hitting a four-month high on Tuesday on the back of strong US CPI data, before easing on Wednesday as investors used the selloff to step back in. Meanwhile, five-year yields rose just as much as two-year peers on Wednesday, reflecting demand for the belly of the bond curve. This is often an early sign that investors are beginning to prepare for rate cuts, even as they remain unclear as to when they will begin.
These moves highlight the ongoing challenge of pinpointing when exactly the BOE and other central banks may stop raising rates, even as disinflation is “set in stone,” according to Charles Diebel, head of fixed income at Mediolanum International Funds in Dublin.
“The market reaction has been pretty strong especially at the short end, as obviously it’s good news inflation is falling at a pace,” he said. “The extent of the reaction is also a function of the dramatic sell off seen after the CPI data in the US yesterday.”
Falling petrol prices helped to slow UK inflation in January, and an ongoing drop in energy prices could offer further support to UK government bonds, according to Alexander Pelteshki, an investment manager at Aegon Asset Management.
That could curb the amount the government has to spend on energy support, with the Resolution Foundation estimating this could drop to £1.5 billion in 2023-2024, compared to the £12.8 billion forecast in November. Bond investors quailed on UK bonds last year following the announcement of the government’s economic plans, as projections signaled record net supply over the coming fiscal year.
“Government bonds issued by the UK offer the most relative value,” Pelteshki said in emailed comments. “The much-improved energy situation will have a direct impact not only on headline inflation, but also on the amount of government debt to be issued during 2023.”
–With assistance from James Hirai.
(Updates prices, adds asset manager comments)
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