As the days grow shorter and winter creeps in, is the outlook for government bonds quite as cold and dark?
Fixed income managers will be closely watching a number of key events over the next few months, which Paul Rayner, Royal London’s head of government bonds, warns could prove ‘very interesting’.
‘We think the Federal Reserve will raise rates again in December, the process of unwinding, reducing the balance sheet is going to begin,’ Rayner said.
‘This month there is the European Central Bank (ECB) meeting on Thursday and we do expect some announcement on tapering, so when you throw all this into the mix, this period of excess liquidity being added to markets for quantitative easing (QE) and bond buying is turning.’
Closer to home, the key event he is looking out for is whether the Bank of England chooses to raise interest rates at the beginning of November. ‘A month ago, the Bank of England was very hawkish. The market now is pricing in an over 80% chance of a hike – it was over 90% a couple of weeks ago.’
Rayner’s colleague, Citywire A-rated Craig Inches, head of short rates and cash, pointed out: ‘After several weeks of relative calm for UK government bonds, a raft of economic data has woken gilt markets from their slumber. Despite the purported dovishness of some members of the Monetary Policy Committee (MPC), the market still has its heart set on a rate hike in two weeks’ time.’
Although Rayner still expects a rate hike at the beginning of November, he thinks the debate has moved on to whether this will just take back the 25bps cut in August 2016.
‘With this hike likely a reversal of last August’s extraordinary policy measures, the longer term path for interest rates in the UK is still likely to be very gradual,’ Inches said.
However, the impact and implications of Brexit have far from passed, as Rayner deems the lack of progress in the Brexit talks as a reason to remain guarded.
‘From that perspective, we remain cautious of government bonds and think [yields] will gradually rise. We don’t think it is going to be a massive bear market, but we do feel they will be higher over the next 12 to 15 months.’
Spectre of inflation
Another element added to the mix is inflation, Rayner points out.
Inches noted while much of the noise around last week’s inflation data focused on the consumer price inflation (CPI) having risen to 3%, the retail price index (RPI) figure came in slightly softer than expected at 3.9%.
‘While less pertinent for the UK consumer, index-linked gilts, which are still measured against RPI, have underperformed this week, with break-evens falling as a result.’
Rayner believes the UK is close to a peak in the recent inflation jumps. ‘There’s a chance that we get one last month [of rises], but we do think inflation is peaking – the impact in the fall of sterling post-Brexit and the doubling of the oil price are beginning to unwind.
‘When we look at asset allocation, the short end of the index has done very well relative to government bonds. We think that has run its course and inflation is now overpriced in the 0-10 year area, so we are running underweight inflation in our absolute return fund, particularly against the US where we think inflation still has room to rise.’
The short end of the index preforming well relative to government bonds is notable with Rayner and Inches’ UK Government Bond fund losing 4.7% over the last year, beating the average managers’ 5.4% loss.