Bond Vigilantes Descend on U.K. as Election Promises Spiral
Politics in Britain has rarely been so divided, but its warring factions are increasingly united on one thing: fiscal largesse is coming. And that could torpedo the U.K.’s high-flying bond market.
Gilts that are beating Treasuries and bunds this year suddenly look vulnerable to JPMorgan Asset Management, BlueBay Asset Management and Nikko Asset Management. The money managers cite election season promises that come with big spending plans by Tory incumbent Boris Johnson and his main opponent, and the prospect of an economic recovery that will lift inflation.
BlueBay and Nikko are taking short positions in the U.K. rate market; Nikko for the first time since Britain voted to leave the European Union in 2016. They reason that no matter which party emerges victorious in December, the era of fiscal austerity is over.
This week Jeremy Corbyn’s Labour Party pledged to deliver free broadband by nationalizing a BT Group Plc unit at a cost of 20 billion pounds ($26 billion). Johnson’s Conservative Party announced plans to reopen local rail networks in “overlooked” towns and cut business rates for shops, pubs and cinemas.
Much of the money for ambitious spending plans of both parties is likely to be borrowed, hitting the bond market with a wave of issuance. At the same time, prime-the-pump policies to boost growth could create inflation that erodes bond returns.
Stimulative fiscal policy “implies higher deficits, and therefore much more bond supply,” said Mark Dowding, the chief investment officer at BlueBay. He’s holding bearish positions in gilt futures and sterling interest rate swaps and said he sees the 10-year benchmark climbing to as high as 2% “over time.”
It’s a bold bet. History in the past decade has shown that gilt yields don’t necessarily follow supply higher. In the 2009-2010 fiscal year, when the U.K. sold a record 227.6 billion pounds of bonds to steer the economy out of recession, yields actually dropped by an average 75 basis points.
Britain is headed to the polls on Dec. 12 in an election aimed at breaking the Brexit deadlock. While uncertainty remains high, bond bears have become more confident that it’s no longer a one-way bet for gilt yields. They expect the new government to use fiscal stimulus to support the fragile economy.
Sajid Javid, the Chancellor of the Exchequer, and Labour counterpart John McDonnell have pledged to loosen the purse strings. Javid announced new fiscal rules this month.
A day later, Moody’s Investors Service placed the U.K.’s Aa2 rating on negative outlook, saying the country’s ability to set policy has weakened in the Brexit era along with its commitment to fiscal discipline.
“Fiscal stimulus will have to be deployed whatever the outcome,” said Grant Peterkin, a portfolio manager at Manulife Investment Management. He’s betting on higher long-term yields through curve steepening trades and trimmed a long position in U.K. bonds.
The influx of new debt will be a bigger factor in yields than during the post-crisis years when safety was tantamount, according to Seamus Mac Gorain, head of global rates at JPMorgan Asset Management.
“There might not be the same demand this time around,” said Mac Gorain. “The economy is not quite as weak as it was back then.”
There are other factors that complicate a bet against bonds.
The U.K. dodged a recession ahead of the now-postponed Oct. 31 Brexit deadline, but the weakest growth in almost a decade and inflation at a three-year low is keeping the tone dovish at the central bank, with some of its policy makers ready to deploy support. Two policy makers -- Michael Saunders and Jonathan Haskel -- voted for an immediate cut from 0.75% at the meeting this month.
But for some, the uncertain macro outlook is overshadowed by the chance a political breakthrough will follow the election, especially if it results in a Tory majority and better chances of an orderly Brexit.
The turning point for Lucas Irisik, a portfolio manager at Nikko Asset Management, came when Prime Minister Johnson’s Brexit plan was approved by the EU and passed in principle by the House of Commons (though the timing remains contentious). Irisik initiated a small short position -- and says he’ll add to it when he sees political stability and growth returning, sapping the haven trade in U.K. government bonds.
“The U.K. economy, particularly in regard for investment, has been held back by an overhang of uncertainty for three years,” he said. “There’s hope that this time around we will be able to move forward in terms of Brexit after the election.”
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