Ahead of Bank of England Meeting, Don't Bet on U.K. Sovereign Bonds

 | May 10, 2017 | 9:00 AM EDT
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In case anyone cares, the Bank of England will decide on interest rates tomorrow. Not that it can do much: Ahead of the general election on June 8, the only prudent decision would be to keep interest rates on hold at their record low 0.25%. That's a real -2.05% if we take into account inflation, which was 2.3% in March and April.

Even though this seems like a good thing -- after all, few people don't like low interest rates -- it does not bode well for fixed income, especially for U.K. sovereign debt assets. On Tuesday, the 10-year U.K. government bond yield rose, although it was softening a bit on Wednesday morning. Yields move inversely to bond prices.

For a long time, investors in Gilts -- as U.K. government bonds are known -- benefited from rising prices as the yields kept falling. This trend is about to stop, if not even reverse, even though there is no sign of monetary tightening from the Bank of England.

The worst enemy of the bond investor is inflation. "One important factor contributing to Gilts outperformance was the fact that sterling strength over 2013-2015 was significantly disinflationary," Gaurav Saroliya, director of global macro strategy at Oxford Economics, said in a recent report on U.K. government bonds.

But after the Brexit vote in June last year, the pound weakened substantially and inflation has been on the rise. We will find out more about the Bank of England's tolerance for inflation tomorrow, when the central bank also releases its inflation outlook and Governor Mark Carney holds a news conference.

Carney already has said several times that the central bank is ready to "look through" temporary overshooting of its inflation target. That is good news for investors and not so good news for people who are asset-poor, because wages have been lagging inflation for years in the U.K.

Even so, Gilts are best avoided. Besides the likelihood of volatility increasing before the election, there is also the longer-term danger that the government will need to increase the amounts it borrows because it would need to fund various programs after the U.K. leaves the European Union.

Already, the government promised the auto industry, and specifically Japanese carmaker Nissan, that nothing will change for it after Brexit. This implies that some sort of state subsidies will be available to make up for additional costs, such as tariffs for exporting to the EU or loss of research grants.

There is also the issue of settling Britain's debt to the EU for commitments it entered into before the Brexit vote; those commitments have been estimated by various analysts and official sources at between £60 billion ($77.7 billion) and £100 billion. Such an amount, if indeed the U.K. ends up needing to pay it, definitely would require a lot of public borrowing.

That obligation would come on top of a rising welfare bill, as the U.K. population is aging and private pensions aren't doing all that well. The deficit of the defined benefit pension schemes in the U.K. increased by 8.4% to £245.6 billion at the end of April from March, according to the latest data.

Of course, pension schemes prefer to see higher Gilt yields, so they would benefit to an extent from a selloff in government debt. However, the reality remains that U.K. pensions are underfunded and the government probably will need to step in and support many of the future pensioners in their old age, which would add to future borrowing needs.

Then, there's the issue of quantitative easing. The Bank of England ended its asset purchases in March, removing an important source of demand and therefore contributing to depressing bond prices. It could start buying government bonds again, and after Brexit it even could buy government debt as soon as the Treasury issues it -- something it is forbidden to do by EU law.

But the central bank already owns about a third of the U.K. government debt market. Sure, the pound is still a global reserve currency to some extent, used for diversification for about 5% of global reserves. However, in the case of massive loss of confidence by investors, the exchange rate would crash and there would be little the Bank of England could do.

Buying more government debt only would spark fears that the central bank knows something the markets don't. This would worsen a run on the pound caused by any political instability, such as a messy divorce from the EU. Investors should stay away from Gilts until a clearer Brexit path emerges.

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