Prices for British government bonds are coming under increasing pressure as investors point to gilts as the next market that could experience volatility following last week’s flash crash in sterling.

The pound’s dramatic fall in the early hours of Friday morning has rippled through financial markets, raising inflation expectations and triggering lower prices for gilts. The pressure on the pound was showing no sign of letting up on Tuesday, when the currency fell a further 0.6 per cent to $1.2285.

While weaker sterling has boosted exporters — a positive for the FTSE 100 index — it is also expected to result in higher import costs and domestic price increases, eating away the value of assets with fixed payments — such as bonds.

The pound has fallen 19 per cent against the dollar since the vote for Brexit, reflecting a substantial shift in economic expectations and heightened concerns that the government’s focus on a “hard” split from the EU could have a negative effect on the country’s ability to finance itself through overseas investment.

“Crucially, the UK government’s evident focus upon satisfying populist demands irrespective of the economic repercussions limits the likelihood of a strengthening of sterling near term,” said Richard McGuire at Rabobank.

As a result, market expectations of UK inflation measured by the five-year break-even swap rate have jumped to 3.6 per cent — the highest level since early 2013.

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This has, in turn, damped appetite for gilts, pushing down prices and sending the yield on benchmark 10-year gilts to 1.02 per cent — the highest level since late June.

British government bonds are leading a broader sell-off in developed bond markets as investors scale back expectations of further support from central banks.

The jump in inflation expectations and relatively positive performance of the economy in the wake of the EU referendum has left investors almost certain that the Bank of England will not provide further support to the economy by cutting interest rates or expanding quantitative easing later this year.

Market expectation of an interest-rate cut in December has fallen to just 10 per cent, down from 38 per cent two months ago.

Meanwhile, government speculation about fiscal spending has raised the possibility that the UK is poised to increase the supply of government bonds in the market.

This, said Anton Heese at Morgan Stanley, would be a double whammy for gilts.

The market is starting to price in the fact that the sharp move in sterling was likely to constrain the BoE’s ability to ease monetary policy, he added.

“Even if one is firmly convinced that rising inflation numbers are a ‘head fake’, driven by base effects which will soon wash out … it could be difficult to maintain long duration positions in Europe … In particular we like to keep our outright short 10-year gilt future position.”

However, government borrowing costs remain far below levels seen before the EU referendum — when the yield on 10-year bonds was at 1.36 per cent.

Since then, the BoE has cut interest rates to a 322-year low and begun a new £60bn gilt-purchase programme that is still under way. As Deutsche Bank noted on Monday, the problem investors must grapple with is that shorting gilts puts them at odds with BoE bond buying.



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