UK government bonds – have they really lost their shine?

Bank of England (BoE) bond buying through quantitative easing (QE) has clearly been an important supporting factor. Unlike the Bank of France or the Bank of Spain, the BoE runs an independent monetary policy and has been in a position to buy substantial amounts of its own government’s paper.

As a result of this asset purchase programme, the BoE now owns approximately 30 per cent of the entire gilt market.

This is a much higher proportion than other markets where central banks have been buyers of their own government’s debt.

The BoE’s holding of gilts purchased through QE is now larger than those of domestic pension funds and insurance companies combined. In 2012, QE gilt purchases totalled £125bn and more than offset conventional gilt issuance net of redemptions.

But it looks like large-scale gilt purchases from the BoE could be a thing of the past. The BoE’s monetary policy committee (MPC) voted 8-1 in January in favour of keeping the existing QE programme unchanged.

The BoE has committed to keeping the size of its balance sheet static (with purchases that offset maturing bonds) but this is a very different story from the large net purchases of the recent past.

What about other sources of demand for gilts? For much of 2012, the gilt market was treated as a pseudo safe-haven asset market, in spite of underlying fundamentals that were not supportive.

As such it benefited from investor flows that were avoiding fixed income markets in Europe – including France, Italy and Spain – because of the perceived systemic risk of a break up of the eurozone. Foreign investors now own roughly £400bn in gilts, equivalent to one-third of the entire gilt market. However, the European Central Bank (ECB) initiative to set up the Outright Monetary Transactions (OMT) asset purchase programme has created an effective backstop that has reduced the tail risk of a premature eurozone break-up. Safe-haven demand for gilts is likely to continue to fade as a result.

The weakness of sterling, if it is expected to continue, is another factor that will likely deter foreign investors from putting more money into the market, having the effect of both reducing gilts returns in other currencies and putting upward pressure on inflation via rising import costs. Foreign positions in gilts could be sold down to move money into higher-yielding markets in Europe where event risk is perceived to have reduced.

Then there are the poor underlying economic fundamentals in the UK. Activity levels remain weak, as evidenced by the fourth-quarter GDP release. While weak activity is normally accompanied by downward pressure on inflation this has not been the case in the UK.

In fact, the Bank’s 2 per cent inflation target seems to be moving further out of reach. The BoE has extended the period it is prepared to accommodate above target inflation. Now it does not expect inflation to fall to its 2 per cent target until 2016 at the earliest.

Extending the horizon over which inflation returns to target is a policy that has also been proposed by BoE governor-in-waiting Mark Carney. The upward revision in inflation was driven mainly by sterling weakness and a more robust outlook for energy prices.

Economic growth forecasts were simultaneously revised down to 1.3 per cent for the fourth quarter of 2012 compared with 1.7 per cent in November. This combination seems like a perfectly valid reason for investors to demand a higher yield for holding gilts.

The budget deficit is anticipated to be 6.9 per cent of GDP in 2013/14, and is now expected to be 2 per cent wider than previously forecast in 2016/17, with net debt now not expected to peak until 2015/16 (at close to 80 per cent of GDP).

With safe haven and liquidity preference set to further diminish as supportive factors for gilts, higher-yielding assets look likely to attract fund flows from gilts. The yield gap on the FTSE v the yield on five-year gilts is wide relative to history and – in an improving global risk environment – this is likely to prove increasingly attractive.

Philip Poole is global head of macro and investment strategy at HSBC Global Asset Management