(The opinions expressed here are those of the author, a columnist for Reuters.)
By Jamie McGeever
LONDON, Aug 30 (Reuters) - Yield curves around the world, led by U.S. Treasuries, have flattened relentlessly this year in a sign that growth will not be fast enough to stoke higher inflation as short-term interest rates rise. But, not so in Brexit Britain.
The gap between two- and 10-year UK gilt yields has widened sharply lately, at least relatively speaking. It is on track to rise 16 basis points this week and 15 bps over the course of August - the biggest weekly and monthly increases since 2016.
The 10-year gilt yield rose 18 basis points on Tuesday, the most in a single day for three years. Much of that can be attributed to traders playing catch-up following the UK public holiday the day before, but it’s still an eye-opening move.
Flattening yield curves often point to slowing growth, or worse, especially the U.S. curve. But the corollary doesn’t stand up - a steepening curve portends higher inflation, regardless of whether that stems from a strengthening economy, and most economists reckon the UK economy post-Brexit will be weaker.
Meanwhile, the U.S. curve has steepened barely two basis points this week and compressed 8 bps this month, heading for the sixth straight month of flattening. The curve is the flattest in over a decade and within 20 bps of inversion, the classic recession red flag.
The German yield curve has followed a similar, albeit more gradual, path to Treasuries, steepening 3 bps this week and flattening 3 bps this month.
It’s not hard to see a scenario in which the UK curve continues to steepen, especially if bond traders believe Britain is headed for a no-deal, “hard” Brexit. Either a “bull” steepening led by the short end of the curve, or a “bear” steepening led by the long end, is possible.
Hard Brexit may force the Bank of England to ease policy by cutting interest rates or resuming its bond-buying quantitative easing programme. This would put downward pressure on short-term borrowing costs, in this case the two-year yield, and steepen the curve.
Partly as a result of that policy response, a hard Brexit would almost certainly push sterling lower - perhaps by 10 pct or more - and risk catapulting domestic inflation back above the Bank’s 2 pct target, perhaps toward 3 pct. A rise in the 10-year yields relative to short rates would then follow, steepening the curve in the process.
It doesn’t have to be a no-deal Brexit either. Any deal that the market - especially the currency market - takes a dim view of could see rate hike expectations pulled back or inflationary pressures pushed up, again steepening the curve.
The curve flatted quite substantially in the immediate aftermath of the Brexit referendum in June 2016 as rate and yield expectations were slashed across all maturities and investors sought the safety of long-dated gilts.
Of course, it’s entirely possible that the uncertainty thrown up by a hard Brexit investors could spark similarly heavy demand for gilts, which would push down longer-dated yields.
But that’s not happening, at least not yet, and at least compared to U.S. and German equivalents.
Figures from the BoE on Thursday showed that foreign investors sold a net 17.15 billion pounds of UK government debt in July, the most in a single month since the Bank started compiling the data in 1982.
Much of that may be put down to an unusually large net redemption of gilts worth around 20 billion pounds in July. If overseas investors don’t roll over their purchases, it shows up as a net sale.
Still, with Britain depending on large inflows of foreign capital to fund its current account deficit, this will surely provide food for thought in Threadneedle Street.
On a 12-month rolling sum basis, foreign investors are selling gilts at the fastest pace since 2014, as the chart above from Viraj Patel at ING shows.
Analysts at Bank of America Merrill Lynch reckon a worse-case scenario could see sterling tumbling to $1.10 and foreign central banks dumping 100 billion pounds of sterling-denominated FX reserves, most of which is in gilts.
“This is not our base case, but we think central bank flows are an important source of flow which could determine whether sterling succumbs to a more protracted current account crisis,” they wrote this week.
Reporting by Jamie McGeever Editing by Raissa Kasolowsky