Traders are predicting further trouble in the UK bond market

Investors are predicting UK gilt yields could return to levels seen at the height of last year’s “mini” budget crisis after hot inflation data forced markets to revise their interest rate forecasts.

The yield on the two-year bond, which is extremely sensitive to interest rate changes, reached 4.4 percent on Wednesday following stronger-than-expected inflation.

Yield movements were up sharply from 3.7 per cent at the start of the month, leaving yields on their way to a peak of 4.7 per cent last September, following then-chancellor Kwasi Kwarteng’s disastrous “mini” budget, which included £45bn of unfunded tax cuts. Wednesday’s moves also reinforced the UK’s position as the worst-performing major global bond market so far this year.

This time, traders repriced bonds and swaps after weeks of strong inflation and employment data, raising concerns that the Bank of England will need to raise interest rates further to keep inflation under control. Yields rise when bond prices fall.

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Paul Brain, global bond fund manager at Newton Investment Management, said he had been looking for a jog, but the sharp rise in core inflation had given him “pause”.

“The market will reprice what the Bank of England is going to do,” Brain said. “We are hesitant because it will take some time for the shock to penetrate the market view.”

Line chart of December 2023 swap market rates (%) showing UK interest rate expectations for December have jumped higher

Swap markets are pricing in three or possibly four more rate hikes by December to a peak of 5.4 percent, a sharp increase from the expected peak of 4.8 percent at the end of last week.

“I think there is further underperformance [of UK bonds] come on,” said Imogen Bachra, head of UK rates at NatWest, who now believes the BoE will raise rates to 5 percent by the end of the year, having not forecast another rise ahead of April’s inflation data.

“We could talk about a peak above 4.5 percent for 10-year-old gilts, and close to that for 2-year-olds,” he said.

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Investors are particularly concerned about the rise in core inflation, which strips out volatile food and energy prices, which rose to 6.8 percent in April from 6.2 percent the previous month.

BoE Governor Andrew Bailey acknowledged on Tuesday that there are “very big lessons to learn” in setting monetary policy after the central bank failed to forecast the recent rise and persistence of inflation.

While bond prices rallied last autumn after the BoE bought £19bn worth of sows for financial stability reasons, the yield on 10-year UK debt has risen from 3pc in February to 4.2pc today and is close to “mini”. ” 4.5 percent budget peak.

Quentin Fitzsimmons, senior portfolio manager at US asset manager T Rowe Price, said the rise in UK yields following last year’s “mini” budget will act as a “magnet” for bond prices.

“The Gilded Market raises an amber flag – if not a red flag backwards – to Kwasi Kwarteng.[Liz] The Truss disaster and I don’t see what’s going to stop it short of a very significant recession,” he said.

Line chart (percentage points) of the UK 10-year sovereign debt spread over Germany, showing the widening gap with Europe

UK bonds have underperformed other major bond markets this year, reflected in the widening “spread” – or difference in yields – between the US and Europe, which indicates that investors are demanding a premium for UK bonds.

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However, some investors saw the sale as a buying opportunity. “For the first time in five years, we’ve gone ultra-long in our gilt funds,” said Craig Inches, head of rates and cash at Royal London Asset Management.