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Gilt by association

The BoE decision to hold QE at £200bn will see UK Government bonds suffer in the medium term

The decision by the Bank of England not to expand its asset-purchase facility beyond £200bn came as no great surprise earlier this month.

While the UK economy limped out of recessionto post a fourth-quarter gross domestic product of 0.1 per cent, lower than the expected 0.4 per cent, money supply fell by a record 1.1 per cent month on month in December.

These factors were countered by a higher than expected December inflation figure (the consumer price index rose to 2.9 per cent year on year), improve ments in the property market (the Nationwide house price index increased by a larger than predicted 1.2 per cent month on month) and improvements in lead economic indicators such as purchasing managers indices.

The statement from the BoE was relatively dovish, recognising there would be a gradual recovery in growth and acknowledging CPI had risen sharply to well above the 2 per cent target, a rise it attribued largely to petrol price inflation and the reduction in the main VAT rate a year earlier dropping out of the calculation.

The bank also made it clear it is leaving its options open on further asset purchases, stating it “will continue to monitor the appropriate scale of the asset-purchase programme and further purchases would be made should the outlook warrant them”.

So, what does the decision not to expand the assetpurchase facility any further mean for the UK Government bond market?

Immediately following the announcement, yields moved marginally and while there was a slight sell-off, they quickly fell to where they were before the news.

However, there is likely to be more of a negative impact in the medium term. With the UK Debt Management Office having to issue more than £200bn-worth of gilts this year and the BoE – a significant buyer of gilts – leaving the market, yields will be forced higher.

This increase in yields will be gradual over time as moresupply comes to the market, with medium-dated gilts being most affected.

At some point in the future the BoE will have to consider a quantitative easing exit strategy although, realistically, the Monetary Policy Committee will look to use rate hikes and target reserves before it starts to sell gilts back to the market.

The additional sale of gilts into an already oversupplied market will drive higher yields. Another driver of yields in 2010 will be demand for UK Government debt. Historically, overseas investors have been big holders of UK Government debt but a potential downgrade fuelled by the large Budget deficit would affect demand.

Finally, the upcoming general election will be another important factor determining policy rates and gilt yields. The party in power will need to take decisive action on the Budget deficit but we cannot totally rule out a hung Parliament.

This would be the worst-case scenario for the economy as important policy decisions would be more difficult to make.

Without a credible plan to reduce the Budget deficit, the UK Government debtrating would be more at risk of a downgrade by the ratings agencies.

With the increase in supply and the uncertainty over fiscal policy likely to drive gilt yields higher, we are looking to position our funds underweight UK Government debt versus the benchmark and, in particular, 15- to 25- year gilts.

We favour shorter-dated gilts as we feel this area of the curve should remain well supported with the BoE’s expected policy of keeping rates “lower for longer”.

Daniel Ford is a fund manager at Santander Asset Management


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