Bleaker growth outlook favours Gilts vs Bunds

By Emelia Sithole-Matarise - Analysis

LONDON (Reuters) - A British economy set for a more torrid time than the euro zone's looks likely to lead government bond investors to favour gilts against Bunds and squeeze their yields closer to parity in the coming year.

Revised data on Friday showed the economy failed to grow in the second quarter for the first time since the early 1990s, bolstering expectations the Bank of England will have to cut rates even though inflation remains high.

The economy has not officially contracted, unlike a euro zone which showed negative growth in the second quarter, but forecasts show it tipping into a technical recession in the third and fourth quarters.

Analysts say the economy is more vulnerable to the global economic slowdown due to its greater exposure to the housing market bubble and an ongoing shakeout in the financial services sector.

"Certainly the economy is fundamentally and structurally more sound in the euro zone compared with the UK," said Kenneth Broux, markets economist at Lloyds TSB in London.

"So if I had a choice purely on a yield play you're probably looking at gilts outperforming Bunds."

Gilt markets anticipate a rate cut from the current 5 percent before the end of this year, with calculations based on sterling overnight interbank rates -- SONIAs -- showing an 85 percent probability of one cut in December.

Economists in a Reuters poll last week predicted the Bank would leave rates on hold until year-end then cut by 25 basis points in each of the first three quarters in 2009. The poll was taken, however, before the latest growth data.