The latest UK government ten-year bond sales saw the highest demand from investors ever, beating the previous month, which was the previous highest demand ever.
This demand has created volatility in bond yields. The UK ten year recently spiked to 5% and then went back to 4.5% on strong demand. UK Yields were near multi-year highs, and investors wanted them.
Further to demand, a wide range of investors were buyers. Private retail investment was the highest in four years.
So why are investors clamoring for UK bonds?
And should we jump into this trade?
Versus the US and Europe, the UK is poised for two more rate cuts in 2025.
The number of rate cuts in the US and Europe is less certain.
In the US inflation is running hot, and in Europe interest rates are already low, both dynamics that mitigate interest rate cuts.
When we look at the UK versus the US, UK rate cuts make sense.
The US has 4.5% interest rates on its ten year bond and economic growth was 3%. The UK’s economy is barely showing growth and has 4.5% rates. With such a gap between economic growth rates, interest rates should not be equal.
A more concerning reason for UK interest rates going down is the possibility of a UK recession in 2025. Economic growth was -.1% in 4Q 2024. If it hits negative in 1Q 25, it’s a recession. In recessions, it’s a good bet that governments will lower interest rates to try and jolt economic growth back to life,
Along with anticipated lower interest rates, tax treatment of UK bonds may be another reason for strong investor demand. In the UK investors are only taxed on the interest received, the coupon. Capital gains due to lower interest rates are not taxed. Thus, most bonds in the UK have low coupons (allowing for a low tax).
Adding fuel to the fire, low coupon bonds are more sensitive to interest rates than high coupon bonds. Low coupon bonds move more when rates decline.
But can the UK lower interest rates?
Economic growth, and interest rates differences with the US and UK say they can, but inflation may say something else. In January, UK inflation climbed to the highest level in 10 months, boosted by the cost of airfares, motor fuel, food and the imposition of value-added tax on private school fees.
The actual numbers were: Consumer prices up 3% from a year earlier, accelerating from a 2.5% pace in December, above the 2.8% forecast by economists and the Bank of England.
After these numbers, it didn’t take traders long to respond. Consensus is now for two more quarter-point reductions this year, a significant retreat since last week, the week of strong buying.
It is hard for an economy like the UK to maintain high interest rates when its bond yield is similar to the US at 4.5%, but growth is barely 1% versus 3% in the US.
Europe realized economic growth is anemic and slashed rates way below the UK.
So, in the end, rates will probably go down in the UK in 2025.
The key question will be how many times and by how much in total.
Investors, both retail and institutional, are rooting for lower rates, as seen in the recent bond issuance.
They may get them.
But a key question is the currency. What will happen with the pound? It will probably go down. This is not good for overall return.
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