June 19 (Bloomberg) -- Shorter-maturity government bonds are heading for their worst first half in six years as Britain prepares to become the first major economy to begin exiting emergency stimulus.
Yields on two-year notes, the most sensitive to Bank of England interest-rate expectations, surged 32 basis points this year to 0.88 percent. That’s pushed the average yield on debt maturing between one and three years to the most since 2009 relative to global peers, according to Bank of America Merrill Lynch indexes.
Investors brought forward bets on a quarter-point rate increase after Bank of England Governor Mark Carney said last week that borrowing costs might start to rise sooner than markets anticipated. That’s setting the U.K. apart from the euro area, where the European Central Bank cut rates on June 5, and the U.S., where the Federal Reserve said yesterday it expects rates to stay low for a “considerable time” after it stops buying assets. Japan is adding unprecedented stimulus to boost growth and inflation.
“It’s a case of the governor getting concerned about market complacency in the face of continued strong economic data,” Michael Riddell, a London-based fund manager at M&G Group Plc, which oversees the equivalent of $417 billion, said on June 16. “We would avoid the U.K. front end.”
With unemployment at a five-year low, house prices soaring and the economy heading for its best year since the financial crisis, investors are betting the BOE will raise the benchmark rate from 0.5 percent -- its level since 2009 -- by February, Sonia contracts show. That compares with May before Carney’s June 12 speech.
The average yield on gilts maturing between one and three years was 0.95 percent as of June 17, compared with 0.79 percent for the equivalent global bond index. That’s the biggest difference since December 2009.
The spread between two- and 10-year gilts narrowed to 183 basis points on June 17, the least since June 2013. The two-year yield will reach 1.4 percent by year end, widening the spread over equivalent U.S. debt to 66 basis points from 41 basis points currently, according to Bloomberg surveys.
Carney’s message was reinforced yesterday when minutes of the June Monetary Policy Committee meeting showed officials were surprised at the “low probability” financial markets attached to a rate increase this year. Only a year ago, some policy makers were arguing more stimulus may be justified.
A rate increase this year would make the BOE the first big central bank to tighten policy. The Fed is expected to refrain until 2015 and the ECB, which raised rates in mid-2011 only to cut them again a few months later, this month announced unprecedented stimulus measures to revive the euro-region economy.
A five-month stretch of below-target inflation provides some breathing space for Carney, who says the economy is still working off the spare capacity created by the financial crisis. Regular pay growth slumped to just 0.9 percent in the three months through April. Consumer prices rose an annual 1.5 percent in May.
“I do think rates will rise a little, but not as much as is priced into the market,” Graham Davidson, a trader at National Australia Bank Ltd. in London, said on June 17. “There is too much priced in for hikes next year.”
Davidson said he was trading that view via short-sterling futures contracts expiring in December, which he purchased following the June 17 inflation data. The contract has fallen this month to yield 0.89 percent yesterday, compared with 0.72 percent on May 30.
U.K. government bonds due in one to three years returned 0.42 percent this year, according to Bank of America indexes. That compares with a 1.1 percent return for European government bonds with the same duration and a 6 percent return for gilts maturing in 10 to 15 years.
“The MPC are closer to raising rates than people thought,” said John Stopford, head of fixed-income at Investec Asset Management in London. “The short end is reasonably sensibly priced in terms of looking for near-term rate increases.”