By Jon Sindreu
Economic growth has been robust in the U.S. and the U.K., and inflation is picking up strongly on both sides of the Atlantic. Yet British government bonds yield far less than their American counterparts. What gives?
In short, investors are betting that the U.S. economy after President Donald Trump's election will be more pleasant than the U.K.'s post-Brexit.
Bond yields broadly track interest rates set by central banks, so they are usually lower when future growth is expected to be weak. Central banks lower rates to stimulate growth.
On Tuesday, British 10-year government bonds, or gilts, closed yielding 1.287%, and 10-year Treasurys traded at 2.486%. For 30-year debt, yields were 1.987% and 3.019% respectively.
Part of the explanation for the gulf is simply that there is a gap in current interest rates: The U.S. Federal Reserve is targeting an overnight rate of between 0.5% and 0.75%; the Bank of England's key policy rate is 0.25%.
What's more, recent history suggests that the Bank of England is less likely to raise rates in response to rising inflation than is the Fed. "The market is biased to try to look through it," said Daniel Loughney, fund manager at Alliance Bernstein.
But growth is key. Even though Brexit has so far supported growth by triggering a 17% fall in sterling against the U.S. dollar, "this benign effect could begin to fade as markets once again start to worry about the costs of a 'hard' departure from the EU with few if any trade concessions," said Pictet Asset Management chief strategist Luca Paolini. Pictet recently increased its exposure to Britishdebt. Prices of bonds rise when yields fall.
Prime Minister Theresa May recently acknowledged that the U.K. would have to forego access to the European single market when exiting the bloc.
Money managers mostly follow the lead of economists in believing free trade to be a good thing, and dislike Mr. Trump's proposals of imposing tariffs on foreign goods and shredding trade deals. After his unexpected victory on Nov. 8, however, they focused on his pledges to cut red tape and lower taxes. Stock markets rallied and bonds sold off.
While British equities have been fairly robust, the fact that gilts have outperformed Treasurys reflect that investors don't think that shedding European regulations will provide a similar boon to the U.K. economy.
Protectionism would likely hit Britain harder: The U.K.'s exports add up to 28% of its economy, while in the U.S. they are less than 14%, data by the Organization for Economic Cooperation and Development show.
The main driver of global bonds selling off in recent months has been signs that inflation is picking up. In both the U.K. and the U.S., expectations of long-term inflation--measured by derivatives called five-year inflation-linked swaps--have risen by broadly the same amount since June 23, the day of the Brexit referendum. That evening, U.K. 10-year gilts closed at 1.375%, much nearer to the U.S.'s 1.742%.
But the prices rises in Britain and America could be of different sorts.
"Should protectionist forces build, which seems likely, inflation will reappear. But, it will be the 'wrong sort'--cost-push, led by tariffs, goods and labor shortages," said Neil Williams, economist at Hermes Investment Management. "Central banks will thus turn a blind eye."
By contrast, inflation expectations in the U.S. seem to be driven by belief in stronger growth--the kind that boosts salaries--rather than Mr. Trump's protectionism. As a result, the Fed is likely to keep nudging up borrowing costs, analysts say, dragging Treasury yields with them. This inflation trade has recently weakened, with 10-year Treasury yields falling Wednesday to a three-week low.
To be sure, investors could get it wrong. In a speech Tuesday, Bank of England rate-setter Kristin Forbes said that, if activity remains robust, this "could soon suggest an increase in bank rate." The pound had a small rally, but gilts were mostly unruffled.
Write to Jon Sindreu at email@example.com
(END) Dow Jones Newswires
February 08, 2017 10:15 ET (15:15 GMT)
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