UK government bonds sell off on higher interest rate expectations

Short-dated UK and eurozone government debt sold off on Wednesday as investors cranked up their expectations of how far central banks will raise interest rates to curb inflation.

The yield on the UK’s two-year gilt, which is sensitive to changes in interest rate expectations, rose 0.2 percentage points to 2.88 per cent — reflecting a significant drop in the price of the government bond. The 10-year gilt yield added 0.11 percentage points to 2.68 percent.

Those sharp moves came as pricing in money markets indicated investors were expecting the Bank of England to lift borrowing costs to almost 3 percent by November, up from projections just a week ago of 2.6 percent and a current base rate of 1.75 percent. Data released last week showed that UK inflation rose to a more than 40-year high in July.

The UK Debt Management Office’s announcement on Tuesday that it will sell £1.5bn in short-term gilts on Thursday has added to the unease, said Antoine Bouvet, senior rates strategist at ING. The sale comes during a time when liquidity, or the ease of buying and selling bonds, has been worsening across European fixed-income markets both due to summer holidays and heightened economic uncertainty.

“It’s nothing massive by any stretch of the imagination but it shows that when you add supply to an illiquid, very nervous market, the impact can be quite sizeable,” he said.

The more volatile moves in gilts become, the worse liquidity will get, Bouvet added. “It’s a bit of a chicken and egg scenario.”

Eurozone bond prices also dropped, with the yield on the two-year German Bund adding 0.08 percentage points to 0.92 per cent and Italy’s equivalent debt instrument rising 0.06 percentage points to 1.93 per cent.

Investors were on Wednesday expecting the European Central Bank to implement 1 percentage point of interest rate rises by October, from a current deposit rate of zero. The ECB raised interest rates by half a percentage point in July, its first increase in more than a decade.

The big rise in bond yields and rate expectations highlights how a surge in natural gas prices in Europe and the UK is increasing concerns about already highly elevated levels of inflation. The European gas benchmark rose 11 percent on Wednesday to €289 per megawatt hour while the UK price advanced by a similar margin to £5.40 per therm. That compares with €200 and £3.49 respectively at the start of August.

Equity markets were relatively muted, with the technology-heavy Nasdaq Composite slipping 0.1 percent and the S&P 500 trading broadly flat. The broad S&P 500 had closed out a third consecutive day of losses on Tuesday.

Europe’s regional Stoxx 600 ticked up 0.1 percent. Declines were more pronounced in Asian markets, with Hong Kong’s Hang Seng closing down 1.2 percent and China’s mainland CSI 300 gauge shedding 1.9 percent, as concerns grow about the indebtedness of the country’s mammoth housing market.

Market participants were also awaiting further clues about the direction of the US Federal Reserve’s monetary policy, ahead of the start of the central bank’s annual gathering in Jackson Hole, Wyoming, on Thursday.

“Caution is the name of the game on equity markets with expectations that aggressive policies to tame roaring inflation will continue despite fresh signs that the US economy is slowing,” said Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown.

Minneapolis Fed president Neel Kashkari, previously perceived as a more dovish US central bank policymaker, said on Tuesday night that the combination of “maximum employment” and “very high inflation” made the Fed’s approach “very clear: we need to tighten monetary policy to bring things into balance”.

On Wednesday, a commerce department report showed spending on big-ticket items in US factories in July rose by slightly more than expected by economists. However, the National Association of Realtors measure of signed contracts to buy previously owned US homes slipped 1 percent in July from the previous month, highlighting the strains in the housing market from rising interest rates.

In currencies, the euro dropped 0.5 percent on Wednesday to $0.991 against the dollar, while the greenback added 0.5 percent against a basket of six other currencies.

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