Gilt sell-off helps shares

The sell-off in gilts continued this week, but for reasons that are little threat to share prices.

Yields on 10-year gilts rose to 2.2 per cent this week, the highest for 11 months. But, while 10-year conventional gilt yields have risen by 0.7 percentage points since the summer, yields on their index-linked counterparts have fallen by 0.3 percentage points.

The fact that real yields have fallen tells us that gilt yields have not risen because the global savings glut and shortage of safe assets have diminished; if they had, real yields would have risen. It also tells us that markets are relaxed about the possibility that rating agencies might soon cut the government's credit rating from its present AAA grade. Such a prospect, says Sam Hill at RBC Capital Markets, "is priced in".

Gilts have, however, sold off more than other top-quality European bonds. The gap between yields on 10-year gilts and their German equivalents is now 0.57 percentage points, an increase of 0.3 percentage points since October. However, this gap is only slightly above the average spread since January 2007 - of 0.5 percentage points - which implies that investors are not greatly worried by the possibility that sterling will fall further against the euro.

Instead, the sell-off in conventional gilts is due to a rise in inflation expectations. The 10-year break-even inflation rate, the gap between conventional and index-linked yields, has risen by a full percentage point since the summer, to 3.2 percentage points.

This partly reflects the belief that the Bank of England will allow inflation to overshoot its 2 per cent target over the next two years. Minutes of the last monetary policy meeting show that three members, including Governor Sir Mervyn King, voted to expand quantitative easing.

It also reflects the expectation that the world economy is picking up - which, while not immediately inflationary, at least reduces the risk of deflation. Purchasing managers' surveys next week are expected to show that manufacturing activity is growing in China, the US and UK. And, although the euro area is still in recession, a survey this week by research group ZEW found that finance professionals' optimism has soared recently, suggesting that a recovery is on the way.

This mix of loose monetary policy and hopes of a global recovery might be bad for gilts, but, while it lasts, it is helpful for equities.

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