November 16, 2018 / 12:31 PM / a month ago

Breakingviews - Watch UK bonds to see when there’s a real crisis

An employee is seen walking over a mosaic of pound sterling symbols set in the floor of the front hall of the Bank of England in London, Britain 25, 2008. REUTERS/Luke MacGregor

LONDON (Reuters Breakingviews) - Sterling is the most sensitive barometer of Brexit fears. The pound slumps each time it looks more likely that Britain may crash out of the European Union without a deal. At the same time, however, UK government bond prices strengthen because bleaker economic prospects mean higher interest rates are less likely. The clearest sign that investors have had enough of the United Kingdom would be when both weaken at the same time.

The UK currency and government bonds have tended to react to political turmoil by moving in opposite directions. Sterling fell nearly 2 percent against the dollar and euro on Thursday after a string of cabinet resignations cast doubt on the future of Prime Minister Theresa May and her Brexit divorce deal. Yet even as the pound suffered its worst day since October 2016, gilts rallied. The yield on 10-year UK government bonds fell more than 10 basis points, to as low as 1.35 percent.

Even more telling was that UK sovereign debt performed better than German and U.S. alternatives. That would not have been the case if investors had become wary of Britain altogether. The gap between the yield on gilts and German bunds narrowed by roughly 10 basis points on Thursday. Meanwhile 10-year U.S. government bonds yielded as much as 174 basis points more than comparable gilts – the widest difference since 1984.

Like currency traders, bond investors think the British economy would be damaged by a chaotic no-deal Brexit. However, they believe this would force Bank of England Governor Mark Carney to defer further rate rises, which is typically good for debt prices. Investors’ ability to apply normal bond logic shows that they are not yet panicky.

It would take a full-blown sterling crisis for the UK central bank to respond by raising rates, ignoring the temporary slump in the pound as it did after the 2016 Brexit referendum. If bond investors believed that was likely, they would be as keen to ditch gilts as currency traders are to sell pounds. For now, however, Britain’s political crisis has yet to become a financial one.

Breakingviews

Reuters Breakingviews is the world's leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.


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