Head of Fixed Income Strategy
Summary: Stronger growth, accelerating wages, and rising unemployment show that the BOE doesn't have inflation under control and might need to continue to hike, although the British economy is quickly deteriorating. That calls for a more aggressive and faster tightening from the Bank of England, increasing the odds for a 50bps rate hike in September. Within this picture, the UK yield curve is poised to invert further, and 2-year Gilt yields to rise and break above resistance at 5.5%. We favor short duration and quality, with the front part of the UK Gilt curve offering an excellent risk-reward ratio for buy-to-hold investors. With rates rising, the list of Gilts traded below par becomes larger, benefitting UK investors considering their tax exemption.
When it comes to the UK, good news is bad news. The economy grew beyond expectations in the year's second quarter, and wages are accelerating, rising the fastest since July 2021. Although that doesn't sound bad, it should be enough for the Bank of England to ring alarm bells concerning inflation and reconsider its monetary policy. Moreover, the unemployment rate surprised to the upside, rising 4.2% versus 4% expected. Therefore, not only does the BOE not have inflation under control, but the economy is quickly deteriorating!
It leaves policymakers only one option: for the Bank of England to hike rates aggressively and fast in a desperate attempt to avoid remaining the last hawk standing as central banks pause and prepare to cut rates in other parts of the world. That opens up the possibility for a 50bps rate hike in September, which, if delivered, will leave markets no choice other than pricing a higher premium on Gilts. As a matter of fact, the rationale behind the BOE's interest rate hikes is becoming more and more blurry, with the central bank switching from 50bps to 25bps rate hikes without accurate forward guidance. That implies that Gilts will remain volatile and elevated until the market has a more precise picture of the economy and monetary policies.
Two-year Gilts are in an uptrend, with the RSI breaking above 60, implying that yields might rise further. If they break above 5.5%, they will find resistance at 5.9%, the highest yield since 2007. Yet, for 2-year yields to rise that much we will need to see markets betting on the BOE peak rate to be well above 6%.
Ten-year yields are also poised to rise but at a slower pace. If yields break above 4.71, they will likely soar to 4.92%. That will result in the UK yield curve continuing to bear flatten and invert further, while yield curves in the US and Europe are likely to steepen. With the BOE behind the curve, demand for UK assets will diminish, putting upward pressure on rates and threatening risky investments.
It means that markets are likely to get highly volatile. Hence, we favor quality and low-duration assets. Although Gilt yields might be rising further they are appealing under a buy-to-hold perspective as investors can lock in 5% risk-free for two years, as the economy deteriorates. In addition, it's currently possible to find Gilts at a considerable discount. As these securities mature at par, UK residents can benefit from these profits tax-free.
Please find below a list of Gilts offered below par.
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