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Bond Market Update. UK Election Uncertainty and Yield Curve Dynamics: Why Short-Term Bonds Are the Better Bet
Althea Spinozzi
Head of Fixed Income Strategy
Summary:
- The spread between 10-year and 2-year Gilt yields turned positive for the first time since May 2023, driven by falling 2-year yields and rising 10-year yields.
- Market participants expect a potential Bank of England rate cut by September, but increased fiscal spending under a potential Keir Starmer government could pressure long-term yields.
- Short-term bonds appear to be a more attractive investment due to their lower risk and favorable yield compared to long-term Gilts.
On Monday, the spread between 10-year and 2-year Gilt yields turned positive for the first time since May 2023. While the disinversion of the yield curve was widely anticipated by markets, the timing is particularly notable as market participants prepare for the UK elections on Thursday.
The marked disinversion was driven by a significant drop in 2-year yields, which fell more than three basis points since Friday to 4.16%, alongside a rise in 10-year yields by six basis points to 4.45%.
This divergence between the two maturities indicates that, in the short term, market participants see a 50% chance of a Bank of England rate cut as early as August and expect a full 25 basis point rate cut by September. In the long term, the possibility of a Keir Starmer victory implies substantial investments to achieve an economic growth target of 2.5%. Robust growth prospects suggest that interest rates are unlikely to be aggressively cut, which could exert pressure on long-term Gilts. Furthermore, increased fiscal spending might lead to inflationary pressures, further affecting long-term Gilts.
Short-Term Bonds Offer Superior Risk-Reward Amid Uncertain Economic Landscape.
This outlook reinforces our belief that short-term bonds are a better choice over their long-term counterparts. Currently, 2-year yields offer a yield of 4.13%, which is 12 basis points below 10-year Gilts and 62 basis points below 30-year Gilts. Yet, 2-year yields provide a win-win solution, as the yield on this tenor would need to rise above 11.68% to incur a loss assuming a one-year holding period. Such a dramatic increase in yields would only be possible if the Bank of England initiated another interest rate cycle, hiking rates by more than 600 basis points. Even if inflation remains persistent or increases due to substantial government investments aimed at boosting the economy, it is unlikely that rates will be hiked by such an extent within a year.
In contrast, the risk-reward profile for longer-dated Gilts is less favorable. Assuming a one-year holding period, the breakeven yield for 10-year and 30-year Gilts is 4.9% and 5%, respectively. In the event of a Starmer victory and increased fiscal spending, these yield levels could be easily reached, making longer-term bonds a riskier investment.
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