Gilt yield heads nearer pre-Brexit vote level

UK government bonds came under fresh pressure on Monday, pushing the yield on the benchmark 10-year gilt to the highest level since the EU referendum in June, as renewed angst over Brexit spreads from the currency to the debt market.

A combination of the inflationary effect of the falling pound and concern Prime Minister Theresa May is pursuing a ‘hard Brexit’ — where control of immigration is prioritised over access to the European single market — has cast a shadow over the pound and gilts since the Conservative party conference two weeks ago.

The 10-year gilt yield, which moves in the opposite direction to the bond’s price, jumped as much as 11 basis points to 1.21 per cent in late morning trading. That is the highest level since June 24, when the shock of Britain’s vote for Brexit added fresh impetus to a global rally in sovereign bonds.

“Because of the market’s ‘hard Brexit’ realisation there has been a clear change in investor confidence and the correlation between GBP and UK assets,” according to analysts at Nomura.

Monday’s sharp gilt sell-off follows a similar move on Friday, when Mark Carney, governor of the Bank of England, said the central bank was prepared to see some “overshoot” in its inflation target. Fears of inflation, which make a bond’s fixed payments less appealing, have been stoked by the 18 per cent decline in the pound against the dollar since the EU vote in late June.

After a tuburlent two weeks, sterling was little changed against the dollar at $1.2166 in late morning trading. For gilts, the move lower in prices sent the ten-year yield above its 200-day moving average, a level that some traders watch and reckon will encourage selling.

The vote for Brexit helped UK government debt outshine rival sovereign bond markets over the summer, with the yield on the ten-year gilt falling from 1.37 per cent on the eve of the June 23 vote to as low as 0.51 per cent in August.

However, Mrs May’s announcement this month that formal negotiations on the UK’s exit from the EU will start by the end of March, alongside signs Downing Street is seeking a hard Brexit, is helping to unwind the gilt rally.

A lack of clarity on the potential outcome of the Brexit talks leaves UK assets at the mercy of the fraught political outlook, analysts said.

“The combination of political uncertainty about the UK’s future relationship with the EU and the sizeable current account deficit have exposed downside potential in sterling that may yet have further to run,” said Rabobank.

The increasingly fractious political climate over the Brexit negotiations will remain a major point of discussion for investors. Reports that Britain is considering continuing to pay billions of pounds into the EU budget after Brexit to maintain cherished single-market access for the City of London and other sectors highlighted the prospect of divisions within Mrs May’s cabinet.

One cushion for the gilt market will come from the BoE’s bond-buying operations, part of the central bank’s efforts to shield the economy from any economic fallout from Brexit.

“With Brexit fears taking a toll on gilts as a result of higher inflation expectations, this week’s operations are also expected to be well offered,” analysts at RBC predicted. “We think developments in credit demand should be watched carefully from this juncture. The BoE’s response to Brexit in August helped to ensure the supply of credit wasn’t impaired, but if demand remains notably weaker, cautious expectations for GDP in 2017 will look more justified.”

While sterling and gilts have been hurt by the political squall over Brexit, the FTSE 100 has benefited as the dollar earnings of London-listed multinationals with earnings are polished. However, on Monday, the FTSE 100 was down 0.6 per cent at 6,970.76, moving away from the record high levels it reached last week. The mid-cap FTSE 250, seen as more representative of the domestic UK economy, was down 0.7 per cent at 17,851.02.

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