GILT investors trying to catch a break in bond markets must know how Harry Houdini felt. Unless the pound rallies, there is no escape from the straitjacket of currency pressure. And without a shift in the UK political mood, sterling looks set to stay on the back foot.

Until this month, sterling was the asset that best reflected investors’ attitude towards the UK’s vote to leave the EU — acting as a market barometer for every new piece of economic data and ministerial pronouncement.

Now, however, that role is also being taken up by the debt market, pushing down prices for UK government bonds and raising the country’s cost of borrowing to levels not seen since the June referendum. Amid rumours of a rift within the government between ‘hard Brexit’ proponents and those more concerned about the potential economic damage of the EU split, the pound has continued on its path of volatile weakening, while gilt prices have plunged.

As the coupon on bonds is set at issue, falling prices mean rising yields, and since the start of October, those on 10-year gilts have jumped by 39 basis points as investors fret about Prime Minister Theresa May’s seeming preference for control on immigration over access to Europe’s single market.

Speculation on nature of split with EU calls into question link between asset classes

The fear in the bond market is attributed to a dawning realisation that the scale of the pound’s 18pc post-Brexit slide has not only slashed returns for overseas investors, but already delivered a bigger-than expected inflationary impetus. That, in turn, could give the Bank of England less incentive to cut interest rates and extend the gilt purchase scheme that helped drive the rally in the bonds.

Annual consumer price inflation last month jumped to a two-year high of 1pc, according to figures released on October 18. A market gauge of future inflation, known as the 10-year break-even rate, jumped above 3pc last week as investors bet that prices were heading for a more prolonged rise than first anticipated.

As a result, gilts have fallen increasingly out of favour — with the benchmark 10-year gilt yield rising to 1.22pc on last Monday — the highest it has been since the UK voted to leave the EU. For the pound and gilts to be sold off in parallel and over a sustained period, is ‘highly unusual’, says Adam Cole, G10 FX strategist at RBC Capital Markets.

The speculation about hard Brexit has brought not just a change in investors’ confidence but a break in the correlation between the pound and UK assets, says Jordan Rochester, FX strategist at Nomura. “The typical reserve currency relationship with higher yields that would see sterling higher on a gilt sell-off, has been broken,” he says. That signals problems for relying on the inflows to fund the UK current account deficit.

The changing dynamic between the two suggests the bottom in sterling has yet to be reached, Mr Rochester adds, “with portfolio inflows less likely to provide the necessary inflows to the UK to plug the current account deficit”.

Some may see it as the start of a deeper funding crisis in the UK, says Mr Cole. However, he views the underperformance so far from gilts as not particularly large, and fuelled by higher break-even inflation rates rather than worries about UK balance of payments. Even so, the risk posed by the UK’s ‘emerging markets-like’ twin deficits cannot be ignored, he notes.

Concerns about the parallel sterling and gilts sell-off are ‘understandable but perhaps not sustainable’, says Thushka Maharaj, global strategist at JPMorgan Asset Management. She is more convinced about the weakness in gilts than in sterling, and JPMAM is positioned for the pound to rally in the short term. “If yields continue to rise to such an extent that it could stem the currency weakness that would change the dynamic — but we remain far from that point today,” says Ms Maharaj.

But while Société Générale macro strategist Kit Juckes agrees sterling and gilts ‘have decoupled somewhat’, it is gilts rather than sterling that look more vulnerable, given the extreme speculative bets against sterling in the market.

Last week, Britain sold £2.5bn of 10-year gilts and this week it plans to sell an ultra-long dated 2065 bond, with the outcome a useful indicator of broader appetite for UK assets.

The FTSE 100 is still benefiting from the fall in sterling, which supports companies in the index that generate their revenues abroad, but the weakness in gilts is consistent with a shift in sentiment across bond markets, as investors question whether the ultra-loose monetary policy that supported prices is coming to an end.

Across US, German and Japanese markets the same lift in yields can be seen — suggesting gilts could have further to fall before investors step back in.

Right now, the degree of uncertainty in the UK makes it a natural focus for investors questioning their bond holdings, says Matthew Hornbach, strategist at Morgan Stanley. His advice is: “If investors want to feed their inner bond bear, we suggest selling gilts.”

Published in Dawn, Business & Finance weekly, October 24th, 2016