By Abhinav Ramnarayan
The risk of Britain crashing out of the EU without a trade agreement has this week dragged sterling to its lowest in almost a year, and the prospect of a no deal Brexit has also infected the UK government bond market in recent months.
One of the clearest financial market signals of future economic activity and growth is the yield curve of government bonds, essentially the difference between short- and long-term market borrowing costs stretching into the future.
In a healthy, growing economy, the further along the curve into the future you go, the higher yields will be to account for growth and higher inflation over time.
When that yield curve flattens, however, it signals concern about future activity. It also tends to crimp lending by reducing banks’ interest margins. When the curve turns negative, or inverts, the market frequently presages a full-blown recession. For the UK in recent months, the gilt yield curve has flattened each time there has been a rise in concern about a no-deal Brexit or tensions between Brussels and London. Bond investors, it would seem, agree with the IMF, the Bank of England, and some of the world’s biggest banks and asset management firms that a hard Brexit will damage the UK economy’s health.
“The gilt curve is reflecting the mess that the UK economy will be in both during the Brexit process and afterwards,” said Mizuho’s Peter Chatwell.
This week the gap between two- and 10-year yields on gilts narrowed as UK trade minister Liam Fox spoke of up to a 60% chance of a no-deal Brexit.