The Debt Management Office's Gilts Sales Matter More Than The Spring Budget.

Summary:

- Higher volumes of Gilt issuance coupled with active Quantitative Tightening will apply pressure on Gilts. However, if inflation falls below 2% in the second quarter of the year, as per consensus, there is scope for BOE to deliver more than two interest cuts expected by markets today.

- Gilts up to three years are appealing as they offer a win-win solution to investors. For example, assuming a holding period of six months, 2-year Gilts yields will need to move above 5.8% before providing a negative return.

- Longer duration gilts remain an excellent diversification tool if a hard landing materializes. However, in the case of soft landing, it's safe to expect 10-year Gilts to trade rangebound around between 3.95% and 4.26% until the macroeconomic backdrop is clear.

Analysis:

Yesterday, the Chancellor of the Exchequer Jeremy Hunt delivered modest tax cuts while pushing tax hikes in other areas to offset the costs associated with the cuts, leaving the economic backdrop broadly unchanged from the Autumn Budget.

At the same time, the Office for Budget Responsibility (OBR) released new economic projections for the UK. These projections showed a reacceleration in growth, with the UK GDP rising to 0.8% this year and 1.9% next year. This is a clear rebound from the last forecasts, which showed 0.7% and 1.4%, respectively. The UK budget and OBR projections failed to add a notable bearish sentiment in Gilts.

More relevant for bondholders was the Debt Management Office’s announcement ahead of the UK budget showing a 9% increase in Gilts sales, from £258 billion to £265 billion the next fiscal year. Long-dated gilts are expected to make up less than a fifth (£35.5 billion) of the total Gilt issuance amount, adding pressure on Gilts with tenors of up to 20 years. Indeed, markets are already contending with the Bank of England's plans to reduce its balance sheet.  

As per the market notice published by the BOE on December 15th, throughout the first quarter of the year,  £8 billion of Gilts will be actively sold, 76% of which are short—and medium-term bonds. Gilts maturing before 2040 make up two-thirds of the BOE's holdings.

Since the beginning of the year, medium-term and long-dated gilt yields have been rising steadily despite a significant slowdown in inflation. Ten-year Gilts have underperformed US and German peers as yields rose by 50bps versus 30bp in Germany and 22bps in the US.

Short-term vs Long-term Gilts: risks and opportunities.

Consensus expects inflation to drop below 2% by the year's second quarter to rebound slightly above 2% until the third quarter of 2025. If such forecasts are confirmed, the Bank of England will see scope to begin cutting rates before summer and to deliver multiple rate cuts before the end of the year, surpassing current market expectations of two rate cuts by the end of 2024. Thus, the yield curve will bull-steepen aggressively, with 2-year yields likely to fall below 4%. In such a scenario, the ten-year gilt yield might adjust slightly lower, but as data shows signs of a soft landing, yields are likely to remain supported. Ten-year yields will likely remain rangebound between 3.95% and 4.26% until the economic backdrop is clear. In the case of a soft landing, improving economic activity might see 10-year yields normalizing around current levels; however, if a hard landing scenario forms, 10-year yields are likely to drop below 4%

Yet, the risk that investors will run is that if the disinflation pace is slower than expected, yields might rise again. Thus, while there is scope to increase one’s portfolio duration, we favor short-term Gilts up to 3 years, as the longer the maturity, the more the directional bet on aggressive BOE cuts.

Risk and reward scenario.

Assuming a six-month holding period:

• 2-year Gilts at 4.3% (GB00BL68HJ26): yields need to move above 5.8% before providing a negative return. While it is true that if inflation proved to be sticky, the BOE might pivot and high rates again, it looks now improbable it will engage in a new tightening cycle, hiking five more times.
• 3-year Gilts at 4% (GB00BDRHNP05): If yields move up by 100bps to 5%, the loss in one portfolio would be -1.3%
• 10-year Gilts at 4.1% (US91282CJZ59): if yields increase by 50bps to 4.6%, investors will start to record a loss of -3.5%. However, if yields by the same amount, they will gain +12%.
• 30-year Gilts at 4-4% (GB00BPSNBB36): if yields move up by 50bps, the loss would be -11%, but if yields move down by the same amount. The gain would be +21%.