Uncertainty to keep US and UK bond yields at their low levels
SINCE the start of April, yields on US, UK and German government bonds have only been going one way and that’s down. Surprising as it might seem, they are all perceived to be relative safe havens as fears of a double-dip recession escalate and the Eurozone debt turmoil appears to rumble on.
On Friday, a disappointing US non-farm payrolls report pushed down yields on 10-year Treasuries to 2.92 per cent, the lowest level since April 2009.
Yields on two-year US Treasuries have dropped below credit crunch lows and those on 10-year Treasuries are back to where they were in April 2009. “The Treasury market’s behaviour reflects a new found wariness that is shared by equity markets,” says Brewin Dolphin’s chief market strategist Mike Lenhoff.
UK 10-year gilts yields held near their 14-month low of 3.33 per cent following both the jobs report and praise from ratings agency Moody’s about Britain’s ability to repay its debt.
The yield represents the return that you get on the bond and it is reflective of how much investors are demanding to compensate for default and inflation risks.
Spread betters who had taken a punt on rising gilt and Treasury prices back in April – yields and bond prices always move inversely to each other – would have done extremely well. But how much further can prices of gilts, Treasuries and bunds rise?
It’s pretty tricky to call because we are in very exceptional circumstances at the moment, says Elisabeth Afseth, a fixed income analyst at Evolution Securities, an investment bank. “Yields on UK gilts are more likely to stay at their lower levels than trade back to where they were earlier in the year because of risk aversion,” she says, adding that there is nothing to warrant yields going much higher from their current levels.
Although we saw fairly robust first quarter corporate profits, the fiscal stimulus had been supporting some key areas of the economy. For example, the end of the homebuyer tax credit in the US in April has resulted in dreadful housing figures over the past month or so.
If we were to see a sharp slowdown in the economy, then the Bank of England might be tempted to expand its quantitative easing (QE) programme. By creating extra demand for gilts, the Bank would effectively be pushing up the price of UK government debt and pushing down the yield.
Consequently, if you already have long positions on these “safe haven” bonds, then it is probably worth holding on to them. Brewin Dolphin’s Mike Lenhoff says: “A short while ago we suggested hanging on to any position in gilts. They are a tiny bit dearer since and probably not worth buying but if you’ve got them, keep them – for now.”
If you aren’t currently betting on bond prices, then you may want to hold off until the direction of the world economy becomes clearer. If data continues to disappoint over the next month or so, then it might be worth reconsidering taking out a long position.
However, one risk that spread betters with a long punt on UK gilt prices should be aware of is inflation. If UK inflation continues to remain high, then the Monetary Policy Committee may feel compelled to start hiking interest rates. Rates and bond prices also typically move in opposite directions so higher rates would not be good news for spread betters already long.
But with little downside risk to the prices of UK gilts, US Treasuries and US bonds over the coming months, a long trade could well pay off.
IN FOCUS | UK GILT YIELDS
The cost of UK government borrowing has dropped to 14-month lows as the markets give the coalition the benefit of the doubt. 10-year gilt yields are now at 3.4 per cent while two-year yields have also drifted down to 0.73 per cent.
Having been moving around the 3.6 per cent mark since last August, 10-year yields began to rise from December onwards on the back of anxiety about the Labour government’s lack of a credible plan to deal with the deficit, as well as a lack of a detailed debate about spending cuts. 10-year yields reached a peak of 4.2 per cent in February (just under the current rate of 30-year yields) and stayed around the 4 per cent level up until the establishment of a new government after the election, when the descent began.
However, as CMC Markets’ Michael Hewson remarks, we are still in something of a “honeymoon period” – the great test of market confidence will come upon the release of detailed spending reviews in October and the government’s likely battle with public sector unions. Nonetheless, demand for UK gilts remains solid, particularly given the uncertain outlook for the US economy and the ongoing Eurozone debt problems.
Juliet Samuel