UK Bond Market in Jeopardy

The prospect of a messy divorce between the UK and the European Union threatens to overwhelm support for nation’s bonds from the Bank of England’s asset purchases.

Gilts have been the worst performers in the developed world this month as a sliding currency pushed investors’ expectations for consumer-price growth to a more than two-year high. Still, with the Bank of England having committed in August to buying £60 billion ($73 billion) of bonds over six months, that move pales in comparison to the currency’s 18% drop since Brexit, Bloomberg reported.

Despite the BoE’s support, the danger signs for gilts are mounting. Bets that inflation may stay the central bank’s hand have seen traders remove wagers on interest-rate cuts all the way through 2017.

On top of that, should Prime Minister Theresa May’s government purse a departure from the EU that deprives the country of tariff-free access to the single market, it may create an even more toxic environment for bonds, boosting prices for domestic producers while hurting exporters’ prospects.

With the government eyeing fiscal stimulus to support growth, a dramatic increase in funding costs may ultimately prove a more serious problem than the currency’s weakness.

“UK government bonds are among the most vulnerable assets,” said Alberto Gallo, London-based head of macro strategies at Algebris Investments LLP, which oversees $5.2 billion. “They are at these levels because the BoE is still buying them, but that’s an artificial level. With sterling declining more and more, the BoE will be under pressure from inflation.”

Algebris has a short position on gilts, Gallo said, meaning a bet the assets will decline.

The yield on UK 10-year gilts rose 13 basis points, or 0.13 percentage point, this week, adding to a 22 basis-point increase in the previous five days. It jumped to 1.15% on Friday, the highest since the June 23 referendum. Yields touched a record-low 0.5% in August, and were as high as 1.99% on the last day of 2015.

Gilts lost 2.3% in October through Thursday, the biggest decline among sovereign markets tracked by the Bloomberg World Bond Indexes.