Hedge funds rush to unwind bets against gilts

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Hedge funds have been rushing to unwind bets against Britain’s £2.5tn government bond market as investors become increasingly convinced that the Bank of England is nearing the end of its rate rising campaign.

The total value of the UK’s bonds borrowed by investors to wager on a fall in prices this week dropped below £65bn, according to data from S&P Global Market Intelligence – its lowest level since at least 2006. 

It later nudged a little higher after the Bank of England paused interest rate rises on Thursday.

The decline in short positions comes as gilts have staged a comeback in recent weeks, after having been the worst performing leading sovereign debt market in the first half of the year. An Ice Bank of America index of gilts has risen by 2.7 per cent over the past month, although it remains down by over 3 per cent since the start of the year.

“I think we have reached terminal rates in the UK,” said Nikolay Markov, senior economist at Pictet Asset Management. “It could be very optimal to be long gilts as recent inflation was much softer than expected last month and we might not see second round effects coming from the labour market.” 

Short positioning on gilts has fluctuated in recent years, surging in late 2016 and 2017 in the aftermath of the UK’s decision to leave the EU and again in 2021 when the Bank of England was seen to be slow in tackling the threat of inflation.

When yields were close to historic lows, betting against gilts was a relatively cheap trade — investors with short positions have to pay the interest rate received by holders. But the total value of shorts has plunged while rates climbed over the past year and a half and the decline has extended as investors anticipate an end to the BoE’s tightening cycle.

Markets are now pricing in a 60 per cent probability of one more rate rise to 5.5 per cent by early next year, having in June expected a peak rate of 6.5 per cent. A closely watched survey published on Friday showed UK economic activity has fallen at the fastest pace since January 2021, suggesting the chances of a recession have increased.

“We believe the medium-term fundamentals for UK gilts have improved given a weakening growth outlook, a softening labour market and an improving outlook for domestic inflation,” said James Bilson, a fixed-income strategist at Schroders. 

“We’re focused on buying gilts in the five and six year part of the curve, we think rates have gone high enough and, as the economy starts to slow, more people will price in more cuts,” said Craig Inches, head of rates and cash at Royal London Asset Management. 

But some investors think the lion’s share of the recent gilt rally may be over, with the BoE cautioning there was “no room for complacency” on inflation, while officials have not ruled out another rate rise in the coming months. 

“What worries me is even as unemployment creeps up, wage growth is continuing at a pace inconsistent with low inflation,” said Gordon Shannon, a portfolio manager at TwentyFour Asset Management. 

“Gilts at the front and long end aren’t rallying as might have been expected, which makes me wonder if the market worries inflation will have to be revisited [and tackled with tighter monetary policy],” he added. 

The BoE also confirmed that it would increase the pace of its quantitative tightening programme of balance sheet reduction for the year ahead from £80bn in 2022-23 to £100bn in 2023-24. It said the move would have a “modest” impact on prices.