Investors love to hate gilts as Brexit divorce deal nears

A Brexit deal for Christmas, and a rate hike for spring. This is what investors shorting the gilt market are betting on.

UK government bonds have fallen in the past week on signs of progress towards a Brexit divorce deal, leading Investec Asset Management, Morgan Stanley and Societe Generale to bet on further declines. An agreement and parliamentary approval this year could give the Bank of England confidence to lift interest rates again in May, compared to market pricing for November – and there’s discussion of the central bank tightening policy sooner.

“February is certainly possible if everything is done and dusted before Christmas,” said Russell Silberston, a portfolio manager at Investec, which is looking to sell gilts and buy the pound. “Even if they go in May, the short end is far too sanguine, and so is pricing in less than one hike over the next 12 months.”

The BOE said last week that the economy could run hot by late 2019, implying a faster pace of hikes than the market is expecting, though it warned any forecasts were dependent on the Brexit outcome. Speculation on a divorce deal in coming weeks has picked up after reports of agreement on UK bank access and a customs union, though officials have denied both.

UK Prime Minister Theresa May is meeting her cabinet Tuesday to study the latest options for a deal. Any Brexit agreement would still needed to be approved by parliament, but if that is ratified the BoE’s Monetary Policy Council could bring forward a rate hike to February, according to Morgan Stanley.

“With Brexit uncertainty being the only factor holding the MPC back from adopting a more vigorous hiking path, we see risk-reward skewed towards higher rates from here,” said strategists including Shreya Chander, suggesting investors short 10-year gilts and bet on the short-sterling curve steepening between December 2018 and 2019.

Ten-year gilt yields have risen seven basis points this month to 1.51%, after sliding in October as fears of a no-deal Brexit increased on missed deadlines in the talks. Two-year yields have added six basis points, after touching a two- month low in late October.

JPMorgan Chase & Co has shifted to bearish on gilts on cautious optimism for a November deal, recommending a steepener trade and selling 10year bonds against Treasuries, though expects the ratification process by UK lawmakers to be challenging.

Even if a divorce is in place this year, the future trade relationship also still needs to be worked out, and the BoE may want to see how non-EU trading partners view Britain before making a move, said Jason Simpson, a strategist at Societe Generale.