Wake-up call for bond funds after Carney rates warning

Bond managers are being forced to rethink their focus on short-dated bonds after the Bank of England governor jolted markets by hinting that rates will rise sooner than expected.

In his Mansion House speech last week, Mark Carney sounded his first hawkish note since becoming governor of the Bank in 2013 by saying rate rises “could happen sooner than the market expects”.

The shock announcement caused sterling to surge above five-year highs and the FTSE 100 index of UK equities fell sharply.

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But it also led to sharp falls in the prices of short-dated bonds, as markets were forced to accept that bonds that mature within 1-3 years could feel a greater impact from interest rate rises that were not expected to begin until 2015 at the earliest.

Bryn Jones, co-manager of the Rathbone Strategic Bond fund, said the announcement did “catch the market a bit by surprise”.

Two-year gilt yields, which move inversely to the bonds’ prices, rose by 15 basis points last Friday in the wake of the announcement. Yields on longer-dated bonds rose less sharply, perhaps because the Bank’s expected volley of rate rises has already largely been priced in for the long term.

Kames Capital’s John McNeill said the announcement would “definitely be bad for short-dated gilts in the two- or three-year region”.

The blow for short-dated bonds comes after investors piled into the area in a bid to reduce their rate exposure, after it became clear that the era of historic-low rates seen since 2009 was coming to an end.

Mr McNeill last week said that given longer-dated bonds, such as 30-year gilts, were driven more by inflation expectations than rate rises then that part of the market now looked more attractive.

JPMorgan’s Iain Stealey, co-manager of the firm’s Strategic Bond fund, said he had reacted to Mark Carney’s announcement by looking to establish short positions on UK gilts, trades that will gain money if prices fall.

The managers said that prices in the bond markets following Mr Carney’s speech indicated a consensus view that rates would rise this November, likely coinciding with that month’s Inflation Report, instead of second quarter of 2015, which was the previous consensus.

The sudden shift in tone from Mr Carney, who in the previous Inflation Report had wooed markets with a dovish tone on rates, has been interpreted by the managers as an attempt to introduce “two-way risk” into a complacent market.

Mr McNeill pointed out that Andrew Haldane, chief economist at the Bank of England, and Jeremy Stein, formerly a member of the US Federal Reserve’s board, had made speeches recently outlining the dangers that “low rates and quantitative easing are leading to excess risk and low volatility”.

But he said Mr Carney was likely less concerned about investor complacency and more worried about complacency in areas such as credit and the housing market.