A British economy set for a more torrid time than the euro zone's looks likely to lead government bond investors to favour gilts against Bunds and squeeze their yields closer to parity in the coming year.
Revised data on Friday showed the UK economy failed to grow in the second quarter for the first time since the early 1990s, bolstering expectations the Bank of England will have to cut rates even though inflation remains high. The economy has not officially contracted, unlike a euro zone which showed negative growth in the second quarter, but forecasts show it tipping into a technical recession in the third and fourth quarters.
Analysts say the British economy is more vulnerable to the global economic slowdown due to its greater exposure to the housing market bubble and an ongoing shakeout in the financial services sector. "Certainly the economy is fundamentally and structurally more sound in the eurozone compared with the UK," said Kenneth Broux, markets economist at Lloyds TSB in London.
"So if I had a choice purely on a yield play you're probably looking at gilts outperforming Bunds." Gilt markets anticipate a rate cut from the current 5 percent before the end of this year, with calculations based on sterling overnight interbank rates - SONIAs - showing an 85 percent probability of one cut in December.
Economists in a Reuters poll last week predicted the BoE would leave rates on hold until year-end then cut by 25 basis points in each of the first three quarters in 2009. The poll was taken, however, before the latest growth data.
In the euro zone by contrast, the European Central Bank is seen leaving rates on hold at 4.25 percent for months to come with the first cut seen in April. And given the ECB's sole mandate of fighting inflation and worries over second round effects, it is unlikely to be as aggressive as the BoE when it eventually eases, strategists say. "To me it's about interest rate differentials or expectations of interest rate differentials," said Richard McGuire, fixed income strategist at RBC Capital Markets.
"Relative to the euro zone we do see outperformance in terms of resteepening of the UK Gilt curve relative to euro zone." A yield curve steepening is where short-dated yields fall faster than yields on longer-dated maturities. The 2-year to 10-year Gilt yield curve has flirted with inversion - where yields on 10-year government bonds drop below two-year yields - in recent sessions. But it has still steepened by an eye-watering 70 basis points since early March.
The equivalent euro zone curve has flattened to 11 basis points from around 53 basis points over the same period - as investors believe the ECB will keep rates on hold for now to keep inflation in check. "If you're going to play that trade, then you should be long Gilts against Europe, but you probably want to play the short end rather than the long end," said Jason Simpson at RBS.
"We still see the risk that the ECB might hike again, whereas in the UK we are looking for cuts ... Given that growth is going to be weak in the next few quarters there's more downside risks to rates for the central bank in the UK than probably there are in the euro area at this juncture." For those who expect German two-year Schatz yields to be rangebound or even rise and for Gilt yields to fall further, now may also be the time for spread narrowing bets - selling Schatz paper and buying equivalent maturity UK government bonds.
Gilts' appeal is also the higher yield they offer over Bunds. The two-year Gilt was yielding 4.57 percent on Friday, 45 basis points more than the two-year Schatz. Ten-year Gilts also yielded 4.57 percent, almost 40 basis points above equivalent 10-year Bund yields. The spread between 10-year Gilts and Bunds has compressed from 73 basis points in early February and McGuire sees it slimming down to at least 20 basis points within six months with potential for convergence.
"If we are right in assuming that there will be deeper rate cuts coming relative to what's priced in the market in terms of the UK eventually, ie in terms of 2009 relative to the euro zone, then 10-year Gilts will also outperform," McGuire said. Still, there are some strategists who feel that the interest rate outlook favours the euro zone rather than UK given that the BoE has delivered three cuts so far this year while the ECB is yet to start easing.
"In general we probably favour being short the UK versus Europe purely because we think the rate dynamic can favour Europe going forward," said Moyeen Islam, rate strategist at Barclays in London. "The 10-year sector in the UK is beginning to look very expensive though we've seen a lot of buying of Gilt futures so to me it seems a natural point to sell," he said.
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