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Hedge funds have been rushing to unwind bets on Britain’s 2.5 trillion pound government bond market as investors become increasingly convinced that the Bank of England’s interest rate hikes are nearing completion.
The total value of British bonds borrowed by investors to bet on falling prices fell below 65 billion pounds this week, the lowest level since at least 2006, data from S&P Global Market Intelligence showed.
The index then edged higher after the Bank of England paused raising interest rates on Thursday.
The fall in short positions comes as gilts have staged a comeback in recent weeks after being the worst-performing major sovereign debt market in the first half of the year. The U.S. ICE Bank UK Treasury Index has gained 2.7% in the past month, although it is still down more than 3% since the beginning of the year.
“I think the UK has reached final interest rates,” said Nikolai Markov, senior economist at Pictet Asset Management. “With recent inflation well below expectations last month, a long GB bond position may be Very desirable, and we probably won’t see a second round of effects in the labor market.”
Short positions in gilts have been volatile in recent years, surging in late 2016 and 2017 after Britain decided to leave the European Union, and again in 2021 when the Bank of England was seen as slow to respond to the threat of inflation.
When yields are near record lows, shorting gilts is a relatively cheap trade – investors holding a short position must pay the interest rate the holder receives. But the total value of shorts has fallen sharply over the past year and a half while interest rates have climbed, and losses will widen as investors anticipate the end of the Bank of England’s tightening cycle.
The market currently predicts a 60% chance of raising interest rates once to 5.5% early next year, while the peak interest rate in June is expected to be 6.5%. British economic activity fell at the fastest pace since January 2021, a closely watched survey showed on Friday, signaling an increased likelihood of a recession.
“We believe the medium-term fundamentals for gilts have improved given the softer growth outlook, softer labor market and improving domestic inflation outlook,” said James Bilson, fixed income strategist at Schroders.
“Our focus is on buying gilts in the five- and six-year parts of the curve, where we think rates are high enough that as the economy starts to slow more people will consider further cuts,” said Craig, the firm’s director. Craig Inches said. Rates and cash from Royal London Asset Management.
But some investors believe much of the recent rally in gilts may be over, with the Bank of England warning there is “no room for complacency” on inflation and officials not ruling out another rate hike in the coming months.
“What concerns me is that even as unemployment climbs, wages are not growing at a pace consistent with low inflation,” said Gordon Shannon, portfolio manager at TwentyFour Asset Management.
“Front-end and long-dated gilts haven’t bounced back as expected, which makes me wonder if markets have to take another look at inflation [and tackled with tighter monetary policy],” he added.
The Bank of England also confirmed that it will accelerate the pace of its quantitative tightening program to reduce its balance sheet over the next year, from £80 billion in 2022-23 to £100 billion in 2023-24. The company said the move would have a “modest” impact on prices.
