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RBS and Paribas say sell gilts, buy US debt as UK vote looms

[LONDON] The resilience of UK government bonds in the face of the most uncertain election in a generation may be about to weaken.

With gilts trading at close to their strongest levels relative to US debt in almost a decade, strategists at Royal Bank of Scotland Group Plc and BNP Paribas SA predict the yield difference will narrow as anxiety builds before the May 7 vote.

Neither the Conservatives nor the Labour opposition are on course for the parliamentary majority needed to govern alone, leaving the fate of both in the hands of minor parties. Nonresidents sold a net 13.7 billion pounds (S$27.1 billion) of gilts in January and February and gilts underperformed US and euro-region debt over the past month.

"The sizable gilt outflows from overseas investors reveal a lack of appetite ahead of what's seen as an uncertain and risky event," said Shahid Ladha, a strategist at BNP in London. "You can have a minority government or a very weak coalition. That increases the risk of another election later in the year." Labour and the Tories are running neck and neck, making it unclear which will take the most seats in the House of Commons. If current polling is replicated in eight days, Labour would have the best chance of forming a government as it can rely on the support of the anti-austerity Scottish National Party.

Expectations the Bank of England will be months behind the Federal Reserve in raising borrowing costs - the US central bank is predicted to move in September - have supported demand for UK debt.

Gilts fell Wednesday as bonds declined across Europe and the Debt Management Office sold 3 billion pounds of securities maturing in 2025.

At 1.76 per cent, 10-year yields are still just over 40 basis points above their all-time low reached in January. Treasuries yielded 44 basis points more than gilts as recently as March 25, the most since 2006, and the spread is still 24 basis points.

RBS strategist Simon Peck sees the spread shrinking to at least 15 basis points. The possibility of a new administration, less committed to austerity than its predecessor, would probably trigger "fiscal slippage" and more gilt issuance, he said. BNP sees the gap narrowing to 20 basis points.

They'll be proven right if previous elections are any guide. The yield premium over Treasuries jumped in the run-up to the May 2010 vote, when an inconclusive result forced the Conservatives to form a coalition with the Liberal Democrats. It also widened before the 2005 election that returned Tony Blair to office with a diminished Labour majority.

"Treasuries are close to their cheapest versus gilts for the past 10 years and there is still room for UK political uncertainty to impact gilts," said Daniel Loughney, a portfolio manager at AllianceBernstein, who helps oversee US$474 billion in London.

The strength of the gilt market to date is also on display elsewhere. The pound has risen more than 3 per cent against the dollar over the past month and traders are betting volatility will subside following the vote. UK shares are at record highs.

Some find that hard to fathom as the prospect of days if not weeks of political wrangling to form a government looms. If Labour takes office, it will need SNP support and leader Ed Miliband has pledged policies criticised by businesses, including increasing taxes on large companies and the wealthy. Prime Minister David Cameron says he'll hold a referendum on whether to leave the European Union if the Tories are re- elected.

"I think it's going to be really choppy and volatile over the coming weeks, as we price in and out the polling and the vote," says Grant Peterkin, who helps manage 161 billion Swiss francs (S$220.8 billion) at Lombard Odier Investment Managers.


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