The Improbable Strength of Gilts

By RICHARD BARLEY
The gilt market is on a tear. And despite persistently overshooting inflation, monetary policy that appears unresponsive and a still-huge fiscal challenge, that doesn't seem likely to change.

Even though 10-year gilt yields at 3.3% offer little outright value, they reflect a world where regulatory policy, euro-zone troubles and continued economic uncertainty are driving cash into gilts.

All of this is a far cry from the first six weeks of the year, when 10-year yields rose to nearly 4.3%; thanks to the rally, gilt investors have now gained 6.08% year-to-date, according to Bank of America-Merrill Lynch. Gilts have outperformed even German Bunds, with the 10-year spread narrowing to 0.73 percentage point from 1.01 percentage point, according to Tradeweb.

The demand-supply picture is a happy one. Foreign investors have stepped up, buying £42.1 billion ($63.81 billion) of gilts and T-bills in the three months to April, perhaps as a diversification away from troubled southern European government bonds. U.K. banks have been buying to build liquidity buffers in line with incoming regulatory requirements, soaking up £34 billion in the first quarter, according to Monument Securities. Meanwhile, prospective supply has fallen to £165 billion and good progress has been made on issuance already, with £62 billion sold in little more than three months. A single syndicated deal recently raised a record £8 billion, or 4.8% of the full-year target.

Inflation, which the Bank of England has consistently underestimated, may yet cloud the picture. The Monetary Policy Committee is clearly wrestling with recent signs that inflation expectations are starting to drift upwards. But to avoid choking off the nascent recovery, it seems unlikely rates will rise anytime soon. The balance between expansionary monetary policy and contractionary fiscal policy may be enough to keep gilt yields low until it is clear which side is winning. That could take months to emerge.

In that light, one way to play the market might be to bet on further curve flattening. If rate-hike pressures build, then two-year yields should rise more sharply than 10-year rates; conversely if the economy suffers as a result of government spending cuts, two-year rates will remain anchored while 10-year yields could fall further.

Write to Richard Barley at richard.barley@dowjones.com