In the last year, developed market bond yields have been cut in half with the last 2 days seeing a safe-haven flight that crashed yields to a new record low. With UK Gilts 10Y under 1% for the first time, Bunds crashing to record lows, Treasuries back below 1.50%, and JGBs smashed -22bps. With peripheral bond risk spiking and default risk surging, amid ratings downgrades, as Bloomberg's Mark Cudmore notes, "gilts may prove worthy of their name, offering a superficial coating of reward that masks significant threat."
Global bond yields hit record lows...
With flows to safety everywhere (though note some selling in JGBs as Nikkei miraculously bounced overnight)
But as Bloomberg's Mark Cudmore notes, while U.K. gilts were a shining beacon for haven flows on Friday, rather than being a risk-free product for uncertain times, gilts may prove worthy of their name, offering a superficial coating of reward that masks significant threat.
Ten-year U.K. yields fell 29 basis points to 1.086% on Friday, wiping off about 1/5 of their annual return in a day and taking the rate to its lowest level since at least 1989
Not only are gilts perceived as a liquid haven asset, but there’s a strong belief that the Bank of England will be forced to cut interest rates to support the economy
That logic might justify the move seen in the front-end –- 2-year gilts paid 27 basis points at the end of Friday, about half what they offered before counting in the referendum began -- but at the long-end, all the risks appear to be for yields to go higher from here
These bonds attracted haven demand even as S&P, Moody’s and Fitch warned Friday that they’re likely to cut the U.K.’s credit rating. Such negative action is increasingly probable and imminent while domestic political turmoil persists
Not only will this hit demand for gilts but, for as long as uncertainty around the U.K.’s future persists, money is likely to flow out of the country. On Friday, that money moved from riskier assets such as equities to sovereign bonds -– the next step will be taking that cash out of the country entirely. Hence, some of the gilt demand may just have been a temporary step on the way to the exit
Bank of England rate cuts may seem the most likely monetary action -– but if the pound continues to weaken there’s a not- insignificant risk that rates will be raised to defend the currency. At the very least, a depreciating sterling may reduce the ability and/or need for lower borrowing costs
And if a full Brexit becomes certain, then concern over the country’s large structural current account deficit will intensify, putting further upward pressure on rates
Panicked markets cause price-distortions and provide opportunities. The risk-reward ratio of long-end gilts may now be skewed very far one way
So just like US Treasuries in 2011, Gilts have rallied in a post-downgrade review world...