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Are Investors in Gilts Acting Rationally?

Low U.K. interest rates are hardly the surprise one might think they are, given the state of the economy and the Bank of England’s continuing efforts to revive it.

Britain is mired in a double-dip recession  where output has fallen again before making up the ground lost in the previous slump. What is more, the prestigious International Monetary Fund has downgraded its forecasts for U.K. growth by more than for any other advanced economy — a distinctly uncoveted distinction. Yet yields on U.K. government bonds, or gilts, are close to record lows. Are investors behaving rationally?

The U.K. returned to recession in the first quarter of this year, with a fall in gross domestic product of 0.3 percent. The numbers were hit by poor fundamentals at home and abroad. Fears about the euro zone crisis continue to prey on business and consumer sentiment around the world — causing a sharp drop in service sector exports, historically Britain’s strongest suit internationally. Consumer spending was weak, depressed by a fall in household income as wages continued to decline in real terms.

On Monday the IMF downgraded its projection for U.K. growth this year to 0.2 percent — lower than its spring forecast of 0.8 percent and a paltry number compared with its projection a year ago of 2.3 percent. For next year it forecasts only 1.4 percent — well below the historical average.

Despite this, the yield on 10-year gilts closed on Thursday at 1.52 percent — down 20 basis points on the month and comfortably in negative territory in real terms after allowing for inflation. The real-term yield on the 10-year is currently minus 0.9 percent.

Despite this? Or because of this? Rates are lower than one would expect given that inflation has remained relatively high despite the slump.

The U.K.’s economic paralysis has prompted countervailing hyperactivity by the Bank of England, which this month announced an extra £50 billion ($78.2 billion) in quantitative easing (QE) — bringing the total so far to £375 billion. Most of this is being used to buy gilts — representing a large chunk of the £1,210 billion in outstanding gilt issuance.

It is hard to overstate the effect of this huge wave of demand in keeping yields not only low in both nominal and real terms, but far lower than in normal times when the underlying U.K. economy is strong. Five years ago just before the crisis began, the nominal yield on 10-years was 5.36 percent, with a real yield of 3.5 percent.

The QE is officially designed to support economic growth by injecting more money into the economy. However, it also sends a signal to markets that the bank is ready and able to act as a buyer of last resort for the U.K. government’s debt should investors be tempted to clear out their gilt portfolios — just as many have for peripheral euro zone bonds. Outright speculators against gilts defy the Bank of England at their peril.

The £1,210 billion-pound question for bond investors is how long QE will be there to boost U.K. gilt prices.

The answer, judging by comments from Mervyn King, the bank’s governor, is: probably for a long time. “When this crisis began in 2007–2008, most people including ourselves did not believe that we would still be here,” King said in June. He added: “I don’t think we are yet halfway through this. I’ve always said that, and I’m still saying it.” This suggests that in the bank’s view, the aftershocks of the credit crunch could last for another five years or longer — involving many more years of unconventional measures by the bank to support the U.K. economy, most likely to be headed by QE. Four or five years would, of course, cover the entire life of short-term bonds and much of the life of 10-years. At 0.53 percent, the yield on 5-year gilts is more than 10 times lower than that of their Italian counterparts, at around 5.4 percent.

If King’s “not yet halfway through” analysis is correct, “these very low levels of short- and long-term gilt yields begin to look more logical to gilt investors,” says Richard Woolnough, fixed-income fund manager at M&G in London.

The bank’s freedom to respond to the faltering U.K. economy through QE has been greatly amplified by the recent sharp falls in inflation. In September 2011 consumer price inflation peaked at 5.2 percent, because of hefty rises in fuel and food prices. But in the past few months the rate has dropped more sharply than anyone had anticipated — pushed lower by easing commodity price pressures and by tepid consumer demand. In June inflation came down with the heavy rain that pelted Britain. Tuesday’s official figures showed that the rate plummeted by 0.4 percentage point to 2.4 percent — only 0.4 percentage point above the target — as clothing retailers slashed prices of summer clothing in response to the wettest June on record.

George Buckley, U.K. economist at Deutsche Bank in London, said, “If inflation continues to surprise to the downside, the hurdle to extend QE further when the current £50 billion of purchases runs out [at the November meeting] may be lower.”

QE also received important psychological support on Thursday when the IMF “welcomed” the bank’s recent announcement of further bond buying.

Because the Bank of England has buttressed faith in gilts, they have become all the more attractive vis-à-vis the debt of countries whose central banks are unable to provide such support: the 17 member states of the euro zone. This has drawn investor money from overseas into the U.K. bond market. The potential for further sharp appreciation of the pound against the euro — a phenomenon generated partly by bond buying — provides an added fillip to gilts for investors from within the currency union: The pound has risen by 12 percent over the past year to €1.28 ($1.62) at the close of European trading on Thursday, with the increase accelerating since April.

In Britain, therefore, bond investors are rationally putting money in gilts in the belief that bad international economic news is likely to keep supporting prices. For much of the euro zone, they are rationally shorting sovereign debt on the assumption that bad international news will send prices falling. Hedge funds are showing increasing interest in strategies around the world based on the idiosyncratic structures, remits and policies of different central banks. This is a perfect example.

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