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Gilts have endured a bruising new year as investors have a big rethink about the timing of Bank of England interest rate cuts this year.
An Ice Bank of America index of UK government debt has sunk by 3.6 per cent this month — more than double its US counterpart — with much of the damage done by an unexpected acceleration of inflation.
The surprise added to the uncertainty in global bond markets as central bankers on both sides of the Atlantic try to steer investors away from bets on rapid interest rate cuts this year.
January’s bond market sell-off comes on the heels of one of the sharpest two-month bond rallies for decades late last year, fuelled by slowing inflation and dovish comments on rates from the Federal Reserve and other central bankers.
“The UK gilt market moved too far, too fast last quarter with significant short covering being one of the key drivers of the rally” said William Vaughan, associate portfolio manager at Brandywine Global, who added that the surprise inflation print this week caught “the now one-way positioned market off guard.”
While the UK’s annual inflation rate unexpectedly accelerated to 4 per cent in December, economic data has been mixed with retail sales data and wage growth this week both softer than the market had predicted.
Still, traders in swaps markets are betting that the UK will deliver 1.1 percentage points of interest rate cuts this year, from the current level of 5.25 per cent, a 15-year high. At the start of the year traders had priced in 1.73 percentage points of cuts.
“Given the uncertain message coming from the data with UK inflation remaining the highest among major economies and wages still growing at around 6.5 per cent year on year, a hawkish bias from the BoE is likely to remain in place for some time,” said Sebastian Vismara, financial economist at BNY Mellon Investment Management.
But gilts have also been hit this year by a global bond market sell-off, as the US economy remains resilient and policymakers warn that they are still focused on inflation.
An Ice Bank of America index of US Treasuries has fallen by 1.36 per cent this month, while the index of German government bonds — the benchmark for the eurozone — has fallen by 1.91 per cent.
Vaughan said that gilts have been more volatile than other bond markets “mainly due to the extreme valuation anomalies we saw last year and the extremely elevated levels of inflation we saw compared to the EU and US.”
Some economists predict that the UK’s underperformance compared with other major bond markets this year will be short lived.
“We expect that the UK will be the first major developed market where inflation will fall back below target,” said Jonathan Peterson, an economist at Capital Economics, estimating that a fall in utility prices will push the consumer price index below 2 per cent as early as April.
Capital Economics forecasts the 10 year gilt yield will fall from its current level of 3.93 per cent to 3.25 per cent by the end of the year.