ETF Securities Research Blog

Short-dated Gilts most volatile

At this point in time, the consequence of the ‘Leave’ EU referendum result for the Gilt curve is hard to predict but the volatility of the 5yr maturity is likely to increase as EU negotiations intensify. While a consensus has emerged on the negative impact of Brexit on UK fundamentals, the UK 10yr yield is down to a record low of 1.08%. We believe this can be explained by the fact that UK Gilts are substantially owned by UK resident (about 70%) and by the lack of investment alternatives limiting capital outflows – countries with the same risk-profile have low to negative yields.

According to the HM Treasury forecasts, UK GDP will be 3.6% lower in 2016 and 6% lower after two years as a consequence of leaving the European Union, as businesses start to reduce investment spending and cut jobs in the short term. A potential increase in public spending to counter the negative impacts from leaving the EU is thus a possibility. The HM Treasury forecasts a 2.7% of GDP increase in public debt toward 2017, followed by a 4.5% increase toward 2018. Lower growth and higher debt could lead to a rating downgrade and an increase of the UK’s risk premium in the medium term. Furthermore, a depreciation of the British Pound is likely to be inflationary since the UK economy is highly dependent on imports. The HM Treasury predicts the inflation to increase by 2.3pp in 2016, leading to higher inflation premium.

Potentially higher inflation expectations and risk premiums could push UK Gilts yields higher – the magnitude of which is dependent on how the UK government will manage its withdrawal from the EU. On the other hand, the current low or negative yield environment makes alternatives to the Gilts hard to find, and only 30% of the UK debt is held by non-UK investors who could reallocate funds to non-GBP alternatives, like US Treasuries. In our opinion, the impact of the Brexit on long-dated Gilt curve is likely be limited in the medium term as defensive inflows are largely offset by credit risk outflows.