UK Gilts: it has to get worse before it gets better

The BOE is behind the curve

The UK Gilt yield curve is much less inverted than the US yield curve. 

The reason behind such a difference is that markets believe that the Fed has finished tightening, and since March, investors have started to position for a pause. A much flatter yield curve in the UK indicates that the BOE's tightening job is not over yet.

Two-year Gilt yields will continue to rise but will unlikely break above 5%

From this morning, markets are pricing three full rate hikes this year and are close to forecasting even a fourth hike bringing the forecasted terminal rate to 5.50%.

Together with quantitative tightening, rate hikes should help swap spreads to tighten back to their mean.

The prospect of a much higher terminal rate brings my focus to the front part of the Gilt yield curve, which will likely remain under pressure in the following months.

In particular, I like to look at the 2-year Gilt yields, which have broken above resistance at 4.20% this morning, and they find their next resistance is at 4.67%, a level that was last seen in September in the aftermath of the Truss' mini-budget. With the terminal rate now expected at 5.25%, it's easy to envision the 2-year rise towards this level.

However, the BOE has a problem with it. The sudden surge in gilt yields last September ignited a series of events that forced the central bank to step in and buy long-dated gilts to tame volatility. That series of events concerned pension funds, which saw margin calls in their interest-rate swap positions triggered as yields surged, but they didn't find enough collateral to post.

The same is likely to happen also this time, and the BOE should be concerned that this moment is approaching because if 2-year Gilt yields break above the 4.68% level, they'll find resistance next at 5.57%, a level last seen in June 2008. Following the events of last fall, it is clear that the financial system cannot take rates that high yet; hence, it is safe to assume that the central bank will not allow rates beyond 5% and step in to cool off the sell-off earlier than that.

For the same reasons, the BOE will be on alert if 10-year Gilt yields test 4.59%.

What instruments should I look at?

• Bond Futures. In the Saxo Platform, you can find Gilt futures which can also be traded as a CFD (FLGM3, FLGU3)
• ETFs. The WisdomTree 10Y 1x and 3x Daily short is designed to provide once or three times the inverse daily performance of the Long Gilt Rolling Future index (1GIS:xlon, 3GIS:xlon). In case you are interested in trading particular segments of the yield curve, you can refer to the iShares UK Gilts 0-5 year (IGLS:xlon), SPDR Bloomberg Barclays 15+ Year Gilt UCITS (GLTL: Elon).
• Cash bonds. If you want to secure some of the high yields in the front part of the yield curve, you can use the instrument screener. In the highlight are bonds in the front part of the curve, such as the United Kingdom's 5% March 2024 (GB0030880693).