To Bond Investors, Brexit Looks Worse Than Trump
Posted by hkarner - 10. Februar 2017
Source: The Wall Street Journal
Investors bet U.S.’s economy after Trump’s election will be in better shape than the U.K.’s post-Brexit
Economic growth has been robust in the U.S. and the U.K., and inflation is picking up strongly on both sides of the Atlantic. Yet British government bonds yield far less than their American counterparts. What gives?
In short, investors are betting that U.S. economic conditions after President Donald Trump’s election will be better than the U.K.’s post-Brexit.
Bond yields broadly track interest rates set by central banks, so they are usually lower when growth is expected to be weak. Central banks lower rates to stimulate growth.
On Wednesday, British 10-year government bonds, or gilts, closed at a yield of 1.213%, and 10-year U.S. Treasurys settled at 2.349%. For 30-year debt, the yields were 1.906% and 2.959%, respectively.
Part of the explanation for the gulf is simply that there is a gap in current interest rates: The U.S. Federal Reserve is targeting an overnight rate of between 0.5% and 0.75%; the Bank of England’s key policy rate is 0.25%.
What’s more, recent history suggests that the BOE is less likely to raise rates in response to rising inflation than is the Fed. “The market is biased to try to look through it,” said Daniel Loughney, fund manager at Alliance Bernstein.
But growth is key. Even though the U.K.’s vote last June to leave the European Union has so far supported growth by triggering a 17% fall in sterling against the U.S. dollar, “this benign effect could begin to fade as markets once again start to worry about the costs of a ‘hard’ departure from the EU with few if any trade concessions,” said Pictet Asset Management chief strategist Luca Paolini. Pictet recently increased its exposure to British debt. Prices of bonds rise when yields fall.
Prime Minister Theresa May recently acknowledged that the U.K. would have to forego access to the European single market when leaving the bloc.
Money managers mostly follow the lead of economists in believing free trade to be a good thing, and dislike Mr. Trump’s proposals of imposing tariffs on foreign goods and shredding trade deals. After his unexpected victory on Nov. 8, however, they focused on his pledges to cut regulation and lower taxes. Stock markets rallied and bonds sold off.
While British equities have been fairly robust, the fact that gilts have outperformed Treasurys reflects that investors don’t think shedding European regulations will provide a similar boon to the U.K. economy.
Protectionism would likely hit Britain harder: The U.K.’s exports add up to 28% of its economy, while in the U.S. they are less than 14%, data by the Organization for Economic Cooperation and Development show.
The main driver of global bonds selling off in recent months has been signs that inflation is picking up. In both the U.K. and the U.S., expectations of long-term inflation—measured by derivatives called five-year five-year inflation-linked swaps—have risen by broadly the same amount since June 23, the day of the Brexit referendum. That evening, U.K. 10-year gilts closed at a yield of 1.375%, much nearer to U.S. Treasurys’ 1.742%.
But the expected price increases in Britain and America could be of different sorts.
“Should protectionist forces build, which seems likely, inflation will reappear. But, it will be the ‘wrong sort’—cost-push, led by tariffs, goods and labor shortages,” said Neil Williams, economist at Hermes Investment Management. “Central banks will thus turn a blind eye.”
But inflation expectations in the U.S. seem to be driven more by belief in stronger growth—the kind that boosts salaries—rather than Mr. Trump’s protectionism. As a result, the Fed is likely to keep nudging up borrowing costs, analysts say, dragging Treasury yields with them. This inflation trade has recently weakened, with 10-year Treasury yields falling Wednesday to a three-week low.
To be sure, investors could get it wrong. In a speech Tuesday, Bank of England rate-setter Kristin Forbes said that, if activity remains robust, this “could soon suggest an increase” in the policy rate. The pound had a small rally, but gilts were mostly unruff