Riding For A Fall

24/02/2012 at 3:59 pm

Each year, Barclays publishes its Equity Gilt Study. Among other things, this magisterial document records inflation-adjusted total returns to UK shares, gilts and cash for each year since 1899. On average, government bonds have returned something in the order of 1-2%, plus inflation, per year. Last year’s returns of 17% – or 21% in the case of index linked gilts – can therefore be regarded as anomalous.

They have also left gilts offering dismally poor value. Ten year yields have been hovering at about 2%, in line with the Bank of England’s supposed target for CPI inflation, and significantly below the most recently reported level of 3.6%. Most starkly, perhaps, all yields on index linked gilts with maturities shorter than twenty years are negative. An investor buying the ten year index linked benchmark and holding it to maturity would be locking in an annual real return of -0.5%.

Gilts, of course, have been seen as a safe haven from the storm that rocked European bond markets over the autumn. They have also enjoyed ongoing support from the Bank of England’s programme of quantitative easing, and from expectations that the base rate will not rise until some time in 2014.

While peripheral eurozone bond markets continue to attract scrutiny, however, the fact is that they have made a strong recovery over the last few weeks. Interest rate expectations change: twelve months ago, the same futures markets that are betting on unchanged rates for the next two years were expecting an increase of 2.5% over the same period. And the Bank will not buy gilts forever. (Indeed, even the increased size of its asset programme at £325bn pales next to the £594bn of net gilt issuance which the Debt Management Office expects to have completed since the start of the recession – see here for the conceptual logic of this.)

It is looking more and more as if the world has moved on from the rabid bearishness of  a few months ago. So far, the gilt market has yet to move with it. It puts this blog in mind of the staple gag in those old Hollywood cartoons where a character runs off the edge of a cliff without noticing and manages to defy gravity for a few impossible seconds, legs paddling furiously in mid air, before looking down and giving in to the inevitable.

Of course, a world calamity that sees the UK collapse into deflation could entail some more upside for the bond market. (The ten year government yield in Japan is 0.98%.) Without such an outcome, however, gilts are surely poised to fall some distance before they reconnect with reality.

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