RPT-ROI-Gilts lose their edge but not yet their attraction: Mike Dolan

By Mike Dolan

LONDON, Nov 18 (Reuters) - Britain's gilts remain a good bet for many investors, but political anxiety and a potential volatility premium have started to scatter a recently crowded trade.

Buying UK government bonds became one of the most popular moves of the late summer as Britain's relatively tight fiscal and monetary policy stood out from its G4 peers.

The government's long-awaited annual budget looks primed for another turn of the screw this month - in stark contrast to the loosening in Washington, Tokyo and Berlin.

Many asset managers have thus likely calculated that UK growth, inflation and interest rates are all headed lower in a "win-win" for bond investors.

Yet, skewed positioning is always a risk, especially in a market that has become a magnet for short-term hedge funds and momentum jockeys. And this risk is being amplified by government skittishness and public relations flubs.

That's what we got last week in a seemingly endless string of stories about possible government leadership changes and a slightly bizarre flip-flop on whether higher income taxes would feature in the budget. And it was enough to scatter the herd.

The ruling Labour Party first suggested it would break election promises and raise income taxes earlier this month, only to row back on that late last week as new information about the country's fiscal situation came to light.

Even though the vague and confusing messaging unnerved some investors, it barely changed the picture for others.

And that's understandable, as the main reason cited for ditching the income tax hike idea was a better growth estimate that could render it unnecessary. The upshot for gilts was thus a marginal thinning of the crowd.

"Fundamentally, nothing has really changed that much," said Mike Riddell, lead portfolio manager for Fidelity International's Strategic Bond strategies.

Riddell said the crowding of the market and valuation effects meant he had pared back conventional gilt positions in recent weeks to about a third of where they were two months ago while remaining modestly long UK bonds.

POLITICAL RISK PREMIUM

But it was the other development last week - murmurs about a Labour Party leadership challenge amid growing concerns about the popularity of Prime Minister Keir Starmer - that has really complicated UK bond market analysis.

While few investors doubt that the Bank of England will now cut interest rates from next month and through next year, the parallel fiscal assumptions hinge on the government's commitment to its self-imposed deficit and debt rules over the coming years.

There is little risk of the government breaking those rules in its current incarnation, and another UK election is years away.

But a change of Labour leadership in the interim - the likelihood of which seemed to increase last week - could create a situation similar to what markets faced in Japan, where new Prime Minister Sanae Takaichi recently upset debt and currency markets by upending fiscal pledges and interest rate guidance.

If a different wing of the UK Labour Party - one averse to tight spending or tax rises - were to mount a challenge to Starmer's centrist approach, then fears of a redrawn fiscal map could spook the gilt market in a similar fashion.

Whether loosening these fiscal rules is warranted economically or politically is another question, but doing so would require a considerable debt market recalibration and could spark a resurgence of gilt volatility, which has fallen by more than a third this year.

Absent such a jolt, that gilt fear gauge is less than a third of the levels seen around the 2022 UK budget shock.

JPMorgan's bond team this week pointed out that a vote on Starmer's leadership would require the support of some 20% of the parliamentary Labour Party.

"Given the noise this week and current poor performance of Labour in the opinion polls, we do think the odds of a leadership contest in the coming months have increased," the U.S. bank told clients. However, the team added that it doubted any challenge would come before regional elections in May.

This rising political uncertainty may leave the gilt market in limbo for some time. It could also force further yield curve steepening akin to that seen this year across other major government bond markets, with BoE easing pulling short-dated yields down while fiscal risk premia push up the long end.

And if comparisons with Japan played out, not only would long-term government debt yields rise but the currency could find itself vulnerable too. As the yen skidded to record lows against the euro last week, the pound fell to its lowest point in more than two years.

Although few buy-and-hold investors appear interested in abandoning gilts just yet, the edgier political horizon could be a casino for hot money.

The opinions expressed here are those of the author, a columnist for Reuters

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