The pound may have been relatively calm in recent weeks, but UK bond markets are seeing signs of Brexit-induced distress.
Investors have been flocking to the safety of longer-dated gilts, preferring them over shorter maturities, a sign that they think the risks surrounding the economy are growing. At the same time, they are betting that inflation will become a headache for policymakers, a scenario that is likely if the UK were to tumble out of the EU without a deal, sending the pound plummeting and the costs of imports soaring.
That would also mean the Bank of England may be forced to raise borrowing costs to quell surging inflation.
Here are three charts that show how the UK rates markets are bracing for uncertain Brexit outcomes:
The UK government bond curve possibly best reflects the concern over the potential economic impact of Brexit. The yield premium on 10-year securities over two-year ones has dropped to its lowest level since 2016 as investors seek the safety of longer-dated debt.
Mizuho International Plc is recommending that investors position for further flattening of the curve, and sees room for the two- to 10-year spread to reach 10 basis points, a level not seen since the global financial crisis.
“Parliament remains in stalemate and the clock is ticking,” said Peter Chatwell, head of European rates strategy at the bank. “Curve flatteners will come back to the fore.”
The threat of a no-deal exit from the European Union remains alive in the nation’s inflation markets. The five-year, five-year inflation swap rate, a gauge of how fast the market expects prices to rise, has touched 3.7 per cent this month, close to a two-year high. That’s in spite of a report Wednesday showing price growth slowed toward the BOE’s 2 per cent target.
Unlike the euro area where dwindling price expectations reflect an outlook for slower growth, the surge in the UK is fuelled by the prospect of a rapid increase in import prices should the nation crash out of the EU on March 29 without any agreement. The BOE has said it may be forced into increasing interest rates under such a scenario.
BOE on Hold
Traders currently don’t expect the UK central bank to raise rates in 2019. That could change dramatically should a Brexit pact be reached, with JPMorgan Asset Management saying that a UK-EU agreement could rapidly herald two rate increases by the BOE this year.
“The prospect of no-deal being removed changes the outlook for the Bank of England this year, assuming the world economy is not falling out of bed,” Karen Ward, JPMorgan Asset’s chief market strategist, said at a press briefing last week in London. “We should see Bank of England rates 50 basis points higher by the end of the year and then that should give 5 per cent again on sterling at least” versus the euro.