(Bloomberg) — There are so many scenarios in U.K. politics now it’s hard for investors to know where to turn. With both main parties aiming to ramp up spending after next month’s election, a bond market spread is likely to widen no matter which side wins.
Whoever forms the next government, there is an increased risk of a swelling budget deficit that would be funded by extra borrowing in the bond market. That is likely to hurt gilts and widen their spread against interest-rate swaps.
If Boris Johnson’s ruling Conservatives win as polls suggest, they will look to end a decade of austerity. Victory for Jeremy Corbyn’s Labour party would open up the spending taps further and also risk capital flight that would widen this swap spread even more. Either way, investors would need to hedge against the possibility of a hung Parliament, where no side has a majority.
Interest-rate swaps, which exchange fixed-rate payments for floating rates, have many drivers pushing and pulling their spread against bonds. For example, a turn in global sentiment away from risky assets means a preference to own government bonds rather than a credit instrument such as a swap. Other factors could include Bank of England asset purchases, funding levels that determine the carry between the two products, and flows from pension funds and insurers.
Higher demand and a lack of supply has seen 30-year gilts outperform swaps in recent weeks, but the increase in issuance from government budget requirements could see gilts falling versus swaps, taking the spread back toward the 2019 summer lows of around minus 60 basis points.
Thursday’s vote split on interest rates at the BOE signaled a short-term easing bias that saw the 2s10s gilt curve steepen, as front-end yields fell on the BOE while long-end yields moved higher with global bonds as well as the expected incoming fiscal wave.
A majority government should create the potential for a BOE rate hike given the fiscal spending outlook and potentially less Brexit uncertainty. A hung Parliament that prolongs uncertainty and could rein in spending ambitions via a coalition government would instead see the swap spread narrow, which could be hedged with receiver options that would pay off on a rally in gilts.
NOTE: Tanvir Sandhu is a global fixed income and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not as investment advice
To contact the strategist on this story: Tanvir Sandhu in London at email@example.com
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