UK index-linked gilts market: outlook and exposures

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The Bank of England’s stance on both monetary and fiscal policy, as well as the state of the UK economy and the attractiveness of UK assets, all hinge on the outcome of the Brexit process.


The political situation regarding Brexit remains highly fluid. Predicting the end result is particularly complicated due to the multitude of plausible outcomes. At the time of writing (March 2019), Parliament appears to have moved to actively prevent a disorderly, no-deal, Brexit. Theresa May’s government is working on a cross-party alternative to her withdrawal deal, boosting the chances of a softer Brexit. But while the tail risk of a no-deal, cliff-edge exit has decreased substantially, the risk of a UK general election being held in the short term has increased.

As to what might happen – some scenarios

1. The withdrawal agreement goes through

Should politicians reach a cross-party compromise allowing Theresa May’s agreement to pass, the transition period in which the UK remains in the single market kicks in. Negotiations on the future relationship between the UK and the EU continue.

Such an outcome would probably provide the market some short-term relief. But the can would simply be kicked down the road for another 21 months (or longer) as details of future trade arrangements will need to be hashed out. It is far from clear whether the UK economy will enjoy a bounce.

Of course, avoiding a disruptive no-deal exit should boost investor sentiment. The British pound would likely enjoy a relief rally.

Consumer spending has not yet been meaningfully affected by worries over Brexit. If anything, stockpiling in preparation for Brexit disruptions has provided a temporary boost to the UK’s manufacturing PMI in recent months.

And should the transition period go live, the Bank of England (BoE) will likely follow through with its hawkish rhetoric and the market could quickly reprice front-dated UK interest rates to reflect faster rate rises in the next couple of years.

Breakeven inflation (BEI) rate spreads, particularly those at the shorter end of the curve, will likely tighten as the market will no longer need to worry about higher imported prices and/or trade tariffs in the near future.

2. No-deal Brexit

While a no-deal Brexit looks less likely, having a political consensus against a no-deal is not enough – there is still no consensus around an alternative course of action. And the risk of a no-deal Brexit could re-emerge through a second referendum. Hence, a no-deal outcome cannot be written off yet.

Should there be a no-deal exit, the UK will likely fall into the World Trade Organization’s (WTO) most favoured nation’s tariff regime. But to trade under WTO law, the UK will have to establish its own schedules, which will then have to be accepted by all WTO members. The UK will also face non-tariff barriers such as EU regulation checks at the borders and trade quotas.

The financial services industry would face significant regulatory limitations and disruptions. In the BoE’s analysis, the economic hit from a no-deal would range from -4.75% to -7.75% in five years’ time.

Sterling would likely take a hit in the short term. Currency weakness, and perhaps also a shortage of goods, would drive inflation higher, again at least in the short term. This in turn will likely push shorter-dated BEI rates higher. Gilts would likely rally as the market prices out future rate increases and instead prices in potential rate rises or even a resumption of quantitative easing (QE).

3. A second referendum

Increasing numbers of MPs appear to have concluded that it is better to ask the people to make an incredibly difficult decision for them. However, the path to the second referendum is uncertain. It would be unlikely to be a repeat of the first one, so the phrasing of the questions on the ballot will not be easy.

A decision to hold a second referendum will probably be market-positive initially as opinion polls suggest that Remain has a better chance of winning this time. However, any positive market reaction will likely be offset by the prolonged uncertainty during the campaign period and the danger that a second referendum might lead to a no-deal Brexit. If the public chose the no-deal option, there would be little time or patience for the EU to continue Brexit discussions.

4. General election

The risk of another vote of no confidence in the government in an attempt to trigger a general election has increased, and given Theresa May’s cross-party attempt to break the deadlock, Conservative Brexiteers would likely be more rebellious. As support for the Conservative party has weakened meaningfully in recent polls, markets may conclude that the probability of a Corbyn-led Labour government is rising.

Labour’s policy agenda, which favours higher income and corporate taxes to pay for higher government spending, renationalisation of utility and rail companies, abolishing tuition fees, limiting the rise in pension age, etc., is generally perceived to be fiscally expansionary and detrimental to gilts and sterling.

That said, we believe market concerns over a Corbyn-led government should be fading. Recent election polls are pointing to greater political fragmentation, making it harder for an eventual coalition government to hammer out compromises on major policy items.

Taking a tactical position in the UK

Given the low visibility on the economic outlook and continued domestic political risks, our active strategies remain focused on near-term tactical opportunities. In duration, Brexit uncertainty, concerns over global growth, the recent BoE QE reinvestment flows, as well as duration demand on the back of the UK inflation linked bond index extension, pushed 30-year real yields to a low of -2% and 10-year conventional yields to just below 1% in late March.

With global growth sentiment recovering after the recent bounce in China’s PMI data, PM May’s moving towards a cross-party solution to break the political deadlock, and the conclusion of the BoE’s reinvestment programme and the index extension, we believe a short duration position at current levels offers some tactical value.


This is an extract from the Q1 2019 Inflation-Linked Bonds Outlook published in March. To read the full version, click here >

For more articles by Cedric Scholtes, click here >

For more articles by Jenny Yiu, click here >

Cedric Scholtes

Co-Head Inflation, Rates Committee Chair, BNP Paribas Asset Management

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