Gilts hit historic low as fall in oil price brings deflation closer to Britain

Downward move in gilt yields may have implications for the cost of servicing the government’s near-£100bn budget deficit

The yield on 10-year gilts touched 1.396%, partly due to the possibility of a rapid fall in oil prices bringing deflation to Britain within the next few months. Photograph: StatoilHydro / Oyvind Hagen /EPA

Falling inflation and the prospect of official interest rates being kept on hold for longer sent the government’s benchmark measure of borrowing costs tumbling to an all-time low on Thursday.
With the prospect of the rapid fall in oil prices bringing deflation to Britain within the next few months, the yield, or effective interest rate, on 10-year gilts touched 1.396% at one point during the day – lower than during the worst point of the eurozone crisis of 2012, and the first time in history it had been below 1.4%. They closed at 1.42%
If sustained, the downward move in gilt yields will have implications for the cost of servicing the government’s near-£100bn budget deficit and reduce the cost of long-term mortgages. Pensions, however, will suffer a drop in investment returns.
Financial markets have reassessed their view of the inflation outlook since the turn of the year, a period that has seen the cost of crude decline to below $50 a barrel, global growth forecasts downgraded by the International Monetary Fund, and a rejection of austerity by Greece.

German inflation figures released on Thursday showed prices were 0.5% lower in January than they were a year earlier – the first time the eurozone’s biggest economy has experienced deflation since 2009.
Signs from the US Federal Reserve and the Bank of England that they have no immediate intention of raising interest rates also helped to drive down interest rates on government bonds, including UK gilts.

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Data from the Office for National Statistics (ONS) showing that UK growth in the fourth quarter of 2014 was slightly lower than expected at 0.5% also helped to bear down on government debt financing costs, with 20- and 30-year gilt yields hitting record lows of 1.921% and 2.102%.
The premium that the 10-year gilt offers over the equivalent German bund narrowed sharply – by about five basis points on the day to 106.5 basis points.
But even with UK government debt yields at such lows, they still offered a better return than bonds issued by other major countries in Europe, where the risk of damaging deflation and slow growth contrasts with Britain’s growing economy.
Jennifer McKeown, senior European economist at Capital Economics, said: “January’s drop in German inflation, well into negative territory, highlights the strength of deflationary pressures in even the eurozone’s strongest economies.
“While falls in prices should prove temporary in Germany, there are downside risks. And the threat of sustained deflation is clearly much greater elsewhere in the region.”
Citi strategist Jamie Searle said gilts would continue to attract strong demand from investors, especially in light of the European Central Bank’s announcement last week that it would be starting a €1.1tn (£830m) bond purchase programme, a move designed to push interest rates on eurozone bonds to even lower levels.
Long-term US bond yields slid on Wednesday as some investors focused on the Fed’s reference to international developments and weak inflation, which they judged might cause it to delay tightening policy.
Safe-haven German bunds rallied on Thursday as worries over Greece’s new anti-bailout government buoyed demand for top-rated assets.
“In the morning gilt prices caught up with the price action overnight with US Treasuries,” said RBC strategist Vatsala Datta.