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Sense of gilt

In recent weeks, the gilt market has been mov-ing to a global rhythm rather than a specifically UK one. The UK has its own market idiosyncrasies which are apparent in the shape of the UK gilt yield curve compared with the US and European curves but the dominant global theme remains the credit crisis and the liquidity crunch accompanying it.

The main impact of the credit crunch is being seen in the US but its influence is being felt well beyond US shores. As the US housing market experiences one of its worst episodes, the impending economic downturn is being anticipated in the rest of the world too.

The US Federal Reserve has acted decisively to try to head off a major collapse but part of the problem is that there has been, and remains, little faith in the banking sector. Players are reluctant to lend to one another for fear of finding that their counterpart is sitting on a pile of mortgage assets that are worth less (if not worthless) and cannot repay the debt.

Lowering short-term interest rates is part of the US solution. Further action is likely to be required, for example, the bailing out of failing financial institutions has already taken place with JP Morgan’s rescue of Bear Stearns.

In the UK, the situation is slightly different. The liquidity crunch that hit Northern Rock so viciously remains a problem for the money markets although the depth of the domestic mortgage turmoil that precipitated the US sub-prime market collapse is probably not of the same scale in the UK. Nonetheless, as many previously low fixedrate mortgages roll off onto floating rates, the impact on borrowers who may have over-extended themselves in recent years could be high and could lead to lower consumer spending in general.

Economic downturn tends to bring with it lower inflation and with lower inflation expectations come lower bond yields. At the same time, a central bank could be expected to respond to forecasts of lower/falling inflation by easing monetary policy and cutting shortterm interest rates.

The problem for the Bank of England is that inflation is currently above target and the price of commodities globally is expected to keep inflation higher than the Bank of England would like, for the short term at least.

At the same time, it is not clear that cutting rates at the short end will provide any traction for a beleaguered mortgage market. Lenders are as likely to hoard liquidity in the current environment as to look to expand their loanbooks and where they are willing, terms are becoming more onerous for the end-borrower.

In recent weeks, yields in the money markets have been rising despite the Bank of England cutting the repo rate. At the same time, gilt yields have been falling, especially at short maturities, driven partly by rising risk aversion as investors seek the security of government debt at the expense of higher-yielding corporate exposure, and due to interest from overseas governments and sovereign wealth funds.

The supply schedule is expected to be much heavier this year, particularly now that Northern Rock needs to be funded through the gilt market, and with an additional skew towards shorter maturities, given the current high demand.

From a fixed-income perspective, our view is that the softening of the economy will not deteriorate into a major recession, nor will inflation collapse below the target level set for the Bank of England. Therefore, the current level of yields at shorter maturities will not be sustained into the long term.

Gilt yields beyond 10 years all the way out to 50 years are forecast to be close to current levels although volatility is likely to remain a feature as sentiment regarding the macro-economic outlook swings around.

The shape of the yield curve at longer maturities is not expected to change and the inversion should remain in place. Institutional demand for bonds with ultra-long maturities has been a feature of the market for some years as pension funds look to derisk and although many bigger schemes have made or begun the transition, there are many more schemes that are expected to begin the process in coming quarters.

Phil Barleggs is head of fixed-income product management at Insight Investment


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