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Brexit Isn’t Roiling UK Bonds

UK gilt auctions have been quite healthy lately, and ordinarily that would not be news. But people have been worried about demand for gilts, believing the high current account deficit and looming spectre of “Brexit” will scare off investors and drive yields skyward, imperiling Her Majesty’s finances. Compounding matters, two big European banks resigned as primary dealers in recent months, blaming regulatory barriers. After an auction for £4 billion worth of five-year gilts just barely went off on 20 January, most presumed a failed sale (when the full offering isn’t sold) was only a matter of time.

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Since that auction, the current account deficit has risen to record highs, and Brexit fears have hit fever pitch. On 20 January, Prime Minister David Cameron hadn’t finished renegotiating Britain’s EU membership terms with his fellow EU leaders. Since then, he has wrapped up talks and scheduled the vote (for 23 June), warnings of economic doom should the UK leave have hit headlines daily, and polls have narrowed considerably. If you follow the popular narrative, this should have further eroded gilt demand.

Yet it hasn’t.

As the very messy chart in Exhibit 1 shows, demand bounced back. Bid-to-cover ratios—the amount of bids relative to the amount of securities on offer—are back where they’ve been for most of this bull market. And in line with the 2002-2007 bull market. That dismal January auction looks more and more like an outlier.

 

Exhibit 1: A Messy Chart of UK Gilt Demand

Source: UK Debt Management Office, as of 2/6/2016. Excludes index-linked gilts.  

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Importantly, it didn’t take significantly higher yields to boost demand. Actually, yields were mostly lower at those more successful auctions. On 20 January, those five-year gilts the Treasury could barely sell (the bid-to-cover ratio was just 1.07) yielded 1.1%. On 2 March, a similarly sized lot of five-year gilts attracted a 1.54 bid-to-cover ratio, yet yields were lower—0.86%. 5 April’s five-year gilt auction saw demand of 2.01 times the amount offered, with yields even lower at 0.80%. Whilst demand ticked down slightly in 1 June’s five-year auction, the bid-to-cover was still a healthy 1.60 and the resulting yield a low 0.86%. Longer-term auctions have witnessed a similar trend, as Exhibit 2 shows. If the current account deficit and Brexit potential made UK debt significantly riskier, Exhibit 2 would not exist.

 

Exhibit 2: A Less Messy Table of UK Gilt Demand

Source: UK Debt Management Office, as of 2/6/2016. Excludes index-linked gilts. 

Now, some will likely argue the recent improvement stems from some changes the UK’s Debt Management Office made to the auction process in an effort to boost demand, and it’s a fair point—but don’t overstate it. One, the changes were implemented in early April, and demand had rebounded by February. Two, the changes aren’t all that significant. Banks were told to boost their minimum bids from 2% of the rolling six-month average of gilts sold at auction to 5%. But that higher bid is for pricing purposes only. They didn’t have to actually raise the amount they bought. As DMO head Robert Stheeman explained: “We have introduced the expectation that banks should bid for a minimum of 5 per cent because we want them to participate more fully in the overall price formation process. But the minimum we expect them to successfully bid on is still 2 per cent. We want to see what prices they would be comfortable owning 5 per cent at.” And it turns out they are comfortable owning 5% at higher prices and lower yields. Which, again, speaks volumes about how markets perceive the UK’s creditworthiness.

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This article reflects the opinions, viewpoints and commentary of Fisher Investments MarketMinder editorial staff, which is subject to change at any time without notice. Market Information is provided for illustrative and informational purposes only. Nothing in this article constitutes investment advice or any recommendation to buy or sell any particular security or that a particular transaction or investment strategy is suitable for any specific person.