Gilts have been one of the assets hardest hit by the war in Iran – why?
- The 2 year gilt yield has risen 34% in five days
- The moves are ‘exceptional’ for a G7 bond market
- Hedge funds appear to have taken highly leveraged positions on UK gilts
If the UK economy was clawing its way back to health, the crisis in the Middle East looks set to disrupt its progress. In particular, gilts yield are showing an unwelcome correlation with the oil price. As it rises, so do UK government bond yields, with all the associated effects for the UK economy.
After a brief respite on Monday, when 10-year gilt yields fell back below 4.5%, selling has resumed. The yield is now sitting at 4.63% for the 10-year gilt and over 4% for the two-year. Gilts have been hit harder than any other major market. The 2-year gilt yield has risen 34% in five days. That compares to just 8.4% for the 2-year Treasury and 22.8% for the German bund.
Why have gilts been hit so hard? The first problem is that gilt yields had come in a long way since the November budget. Her budget may have been controversial, but Chancellor Reeves did a good job in keeping bond markets sweet.
This, coupled with better news on inflation, prompted investors to price in interest rates cuts. It appears that a number of hedge funds had taken highly leveraged positions on UK gilts, betting on an imminent cut. Any spike in inflation caused by higher oil prices makes it less likely that cut will materialise. The market is now pricing in a rate hike.
Bryn Jones, head of fixed income at Rathbones, says: “We had expected a rise in yields, but the moves have been aggressive. They took futures from two rate cuts to one rate hike in the space of a week, which is exceptional behaviour from a G7 government bond market.
He says liquidity dynamics in the gilt market are also under scrutiny: “Bank of England Governor Andrew Bailey has previously raised concerns about the ease with which CTA and hedge fund strategies can short the gilt market, which can amplify selloffs during periods of market stress.”
Certainly, market volatility appears exaggerated compared to the threat, and bond prices turned on a dime when Donald Trump said the war was ‘very complete’ on Monday. A rate hike still looks like an outside scenario. If the war in Iran is relatively short-lived, the Bank of England may choose to look through any increase in inflation.
Bond giant Pimco said it would be sticking to its positive view on gilts, despite the sell-off. Pimco economist Peder Beck-Friis told the Financial Times: “I do not expect the BoE ... to do anything in the next few meetings, unless the situation deteriorates.”
