Right now, UK Government bond market is favoured

Feb 20 2008 by Andrew Miller for The Journal

SINCE the start of the year, the UK government bond market has reacted in a broadly predictable fashion to day-to-day news flow. Yields soared in the second half of January as equity markets tumbled, but recovered again in early February.

Despite the day-to-day volatility, which remains very high by more recent historical standards, a few trends are beginning to emerge.

First, the bond markets remain concerned about inflation, as evidenced by the steady underperformance of ultra-long-dated gilts. In fact, despite the broad-based rally in government fixed-income markets in the wake of equity market turbulence, UK government bonds maturing in more than 10 years have struggled over 2008 so far. Performance of the long-dated sector can be difficult to predict, of course, with price movements often dictated by pension fund demand rather than economic analysis. However, the underperformance appears to reflect concerns that UK inflation may remain stubbornly high over the medium to long term.

Second, inflation break-evens (the level of inflation at which an investor would be indifferent between a nominal or inflation- linked bonds) have been broadly range-bound for the last year or so in the UK. While on a number of measures there are still inflationary dangers lurking in the system, an economic slowdown in 2008 is likely to dampen inflation pressures further down the road at some point, so the outlook here is quite finely balanced. However, a wide range of inflation data last week and the publication of the Bank of England’s Quarterly Inflation Report have pushed inflation expectations to the top of recent ranges, both in short-dated and longer-dated gilts.

We continue to prefer the five to 10-year area of the UK gilt curve, and this strategy has worked quite well since the start of the year, as this sector has outperformed both very short-dated gilts and long-dated gilts in absolute return terms.

So, what does all this mean in the short term? Since the start of the year, returns from other major bond markets have been considerably higher than those in the UK – even more so when taking into account the fall in sterling over the period. To a large extent, this is a reflection of the inflation concerns in the UK, but also the relative worsening of the economic outlook for the US and Europe. While investors still expect the UK to be vulnerable to a US-led slowdown, they have perhaps reassessed their expectations of the timing and extent of interest rate cuts that the Bank of England is likely to deliver, given the strength of recent inflation data.

Meanwhile, it has become clear that the effects of a US-led slowdown on Europe could be more pronounced than some investors had initially thought. Overall, it would appear that the window of opportunity to diversify inter- nationally on a short-term tactical basis has partially closed, meaning that the UK is our favoured government bond market.

Andrew Miller is head of the Newcastle office of Barclays Wealth