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Gruesome UK Government Bond Outlook Could Lift Yields to 3% - Natwest Markets


“The natural buyers of this additional supply might be hard to find,” - Imogen Bachra, Natwest Markets


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The market for UK government bonds is significantly underpricing the extent to which borrowing costs will rise further in the months ahead because the 10-year yield could hit 3% after the Bank of England (BoE) begins turbo tightening its monetary policy in September, according to research from Natwest Markets.

UK government bond yields have rallied strongly already during 2022 in tandem with losses for bond prices that have lifted the payout from 02-year debts from 0.67% to 2.39% while pushing the effective interest rate on 10-year bonds up from 0.97% to 2.31% by Thursday. 

Higher yields are the result of falling bond prices that have bolstered the returns offered by fixed coupon payments after the Bank of England took its gloves off in an ongoing battle to bring down runaway inflation rates that clocked up new multi-decade highs when July’s data was released this week.

Despite the sharp increases in borrowing costs to date, research from Natwest Markets suggests that investors are still underestimating the scale of increases that could materialise if BoE monetary policy exacerbates an already gruesome outlook for government bonds in September.  

“The natural buyers of this additional supply might be hard to find,” says Imogen Bachra, head of UK rates strategy at Natwest Markets. 

Source: Natwest Markets. 

“Gilts are one of the least attractive fixed income assets on a cross-currency hedged basis in the world (competing only with [U.S.] Treasuries for the bottom spot), whilst UK pension funds have been closing their funding gaps at breakneck pace in recent years,” Bachra wrote in a Wednesday note.

Bachra and the Natwest Markets team estimated this week that supply of UK government bonds, known as Gilts in market parlance, will more than double from 2020 levels by next year if the Bank of England goes ahead in September with a tentative plan to begin selling some of its holdings.

The BoE has acquired £895BN worth of UK government bonds under the various quantitative easing programmes launched since the financial crisis of 2008 but said in August that the Monetary Policy Committee could announce outright sales of some assets as soon as next month.

Above: Past changes in supply of UK government bonds over time and relative to changes in demand from various sources. Source: Natwest Markets. 

When combined with the effects of the BoE’s February announcement that it would no longer reinvest money it receives from the UK government when  a bond on its balance sheet reaches maturity, September’s forthcoming decision could see an extra £80BN of supply hit the market in the year ahead.

“Markets are underpricing these risks. Our gilt model suggests 10y yields closer to 3%,” Natwest’s Bachra warned on Wednesday.  

“Our fair value model for 10y gilts brings together our view of supply side risks (using the monthly flow of gilts vs APF), with monetary policy (Bank Rate and market expectations for Bank Rate using the slope of 1y1y vs 6m SONIA), economic fundamentals (inflation and GDP) and global factors (other central bank rates and an index of global economic policy uncertainty),” she added while citing the below chart.

Above: Summary of output from Natwest Markets’ Gilt yield prediction model.

Bank of England monetary policy actions are just one, albeit significant, source of likely additional supply that would weigh heavily on UK government bond prices in the year ahead while lifting government bond yields further.

Other sources include government policies that impact HM Treasury demand for new debt via increased fiscal spending including on things like tax reductions, subsidies for household energy bills and investments in infrastructure.

“Our PCA analysis shows that the 10y point of the gilt curve is the richest point, and given the shape of the yield curve, it is also the sweet spot for being short when it comes to carry and roll,” Bachra said. 

Above: Natwest Markets forecasts for BoE Bank Rate and UK government bond yields of various maturities.