The selloff in UK markets at the beginning of January has created potential opportunities in government bonds, particularly as investors are underestimating the interest-rate cuts necessary to support the economy, according to Fidelity International. Mike Riddell, a portfolio manager at the firm, which manages $926 billion in client assets, believes the dramatic rise in UK yields was largely a result of the market “blindly following” the selloff in US debt.
Riddell pointed out that he purchased two-year swaps earlier this month, betting on lower rates, while also increasing his long position in 10-year gilt futures against US Treasuries. The yield on UK 10-year gilts surged to 4.92% on January 9, the highest level since 2008, driven by concerns over the UK’s elevated debt levels and persistent inflation in the face of a weakening economy. Meanwhile, 30-year gilt yields reached their highest point since 1998.
“I wanted to get bullish on the front end of the curve because it’s more sensitive to Bank of England rates and policy direction,” Riddell explained. As the year began, the market had priced in only two rate cuts by the Bank of England (BOE), a view he deemed incorrect. Riddell now forecasts that the BOE will likely implement three or four rate cuts this year.
Riddell argued that the early January market expectation of 50 basis point cuts in both the UK and the US was mispriced, especially given the weaker UK economic outlook. Since then, traders have adjusted their expectations, with wagers now leaning towards three rate cuts in the UK by year-end, compared to two from the Federal Reserve.
By holding a moderately long position in UK bonds, Riddell is betting that concerns about the UK’s fiscal position won’t result in significant capital outflows. However, to hedge his bond position, Riddell has also taken a short position in the pound, believing it has further room to decline, even if yields rise again. Despite the higher yields, the pound has been under pressure, falling by 2.5% against the dollar since the start of the year, primarily due to broad market pessimism toward UK assets.
“Sterling is fundamentally a bit expensive considering growth differentials, and I see it as a hedge against the possibility that the gilt market could face further difficulties,” Riddell said.
Although the pound has slid against the dollar, its losses against a basket of currencies have been more restrained, largely remaining within a long-standing range against the euro. Riddell is not the only one predicting further declines in the pound. A recent Bloomberg Markets Live Pulse survey found that more than half of 250 market participants expect sterling to fall to between $1.20 and $1.15 by the end of June. The options market is also showing significant demand for contracts betting on the pound falling below $1.20, with some traders even wagering on a decline below $1.12.
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