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Bond investors struggle to see reasons to be upbeat about UK
INVESTORS are so worried about the United Kingdom's prospects that they're ignoring the recent uptick in the economy and betting on an extended period of weakness.
They've piled into havens, driving government bonds to record highs. Yields are close to those in Japan, an economy mired in low growth and high debt levels for the last two decades. And traders are again betting on negative rates in 2021, despite the Bank of England (BOE) saying that officials didn't discuss the monetary policy at their meeting last month.
Those market moves jar with the relative optimism expressed last week by BOE policy maker Jonathan Haskel and chief economist Andy Haldane that the recovery is stronger than anticipated, with the latter saying that growth is "so far, so V". It's a disconnect that has some investors puzzling over whether they are too pessimistic, or whether the central bank faces a wake-up call.
"It's quite a mystery," Russell Silberston, an investment strategist at Ninety One plc, said about recent upbeat comments by BOE officials. "I guess you have to put the bank's optimism in context; so things are picking up a little more quickly, but from historic weakness."
Recent data shows the economic slowdown eased after parts of the lockdown were lifted. There was a marked improvement in manufacturing and construction readings, and a rebound in retail sales and consumer confidence. But for bond investors, there are too many challenges ahead to rejoice.
These include "currency debasement, economic zombification", leaving the central bank struggling to tighten policy, said James Athey, a money manager at Aberdeen Standard Investments.
There's also a concern that while activity might return quickly at first, it could then flat-line, a risk flagged by International Monetary Fund's chief economist Gita Gopinath.
The difference of opinion over the economy's health became evident when the BOE announced it expects to complete its £745 billion (S$1.3 trillion) bond-buying programme around the turn of the year. That effectively halved the amount it purchases per week, making it the only major central bank to scale back the speed of quantitative easing.
Despite the tapering, speculation that the BOE will need to slash borrowing costs to kickstart growth have driven the yield on two-year bonds deeper into negative territory. Governor Andrew Bailey warned banks last month of the challenges sub-zero interest rates would bring, the Sunday Times reported.
While yields on benchmark bonds in Germany, Europe's largest economy, have remained below zero for over a year, bunds broadly reflect European Central Bank monetary policy, rather than just the national economy. Not so in the UK, where investors are instead looking to Japan for clues to the future.
The Asian nation has had negative interest rates since 2016, and this, alongside quantitative easing, has helped to keep bond yields low. While the triggers are different, yields across most of the UK's curve are within a few basis points of falling below Japan's. Both Mr Athey and Mr Silberston say gilts have become expensive.
It was already looking bad for the UK economy, even before coronavirus hit. It entered the year having narrowly avoided a contraction in the last quarter of 2019, with the biggest current-account deficit among Group-of-20 nations. And the slump in productivity was the worst since the Industrial Revolution.
They weighed on the nation's assets as market watchers fretted over the prospect of a painful severing of trade ties with the European Union at the end of the year. Those fears remain, but are coupled with concerns over challenges of overcoming the havoc wrought by the lockdown on the economy.
"What's the economy's biggest shortcoming? It's that the UK has just severed its ties with its major trading partner, causing productivity damage and business uncertainty," said Simon Harvey, a currency market analyst at Monex Europe Ltd. "The economy is now more exposed to the global elements at a time when supply chains are being reassessed and production and consumption are becoming more localised."
Job losses are a concern, with the BOE's Mr Haldane flagging unemployment as a risk for the UK, particularly as the government tapers its furlough programme. That support is scheduled to expire in October, and firms will have to take on more of the share of the burden from August.
Almost half of businesses taking part in the programme expect to let go of furloughed staff when support ends, according to polling by Opinium and the think tank Bright Blue. Over nine million workers were reliant on the scheme as of mid-June.
Chancellor of the Exchequer Rishi Sunak on Wednesday is due to outline further measures to help stimulate the economy and protect jobs.
All the uncertainty means demand for bonds will remain strong for now, even if heavy borrowing could eventually weigh on the bond market, according to John Wraith, head of UK and European rates strategy at UBS Group AG.
Gilt issuance in the first five months of the fiscal year is set to exceed the financial crisis record. The nation's debt-to-gross domestic product is 100 per cent for the first time since 1963.
"It is clear that whatever happens, gross supply is set to stay historically very elevated for a considerable time to come," Mr Wraith added. But "for as long as major economic risks are clear and present - currently Covid, end of the transition period - we expect gilts to remain fairly stable." BLOOMBERG