Despite the Federal Reserve raising interest rates and the Bank of England remaining on hold, we think U.S. bonds offer a more attractive opportunity than UK bonds. There are two main reasons for this.
- Yield levels: As the chart shows, the excess yield on 10-year Treasuries over 10-year gilts is at a 20-year high, despite the economies having similar characteristics. Both are operating close to full capacity, and if anything, inflationary risks are more skewed to the upside in the UK than they are in the U.S. The main difference between the two economies is that the UK has the added uncertainty of the Brexit negotiations, reflected in the rise in the yield differential since June 2016. However, we think the current low level of UK yields already reflects a bad Brexit outcome, and as such, any less-than-bad outcome could bring higher yields (and lower bond prices).
- Return symmetry: As we noted in our secular outlook, there are a number of potential pivot points in the years ahead. If the global economy grows faster than expected, then UK and U.S. bond yields should rise in tandem. However, if the global economy faces a negative shock, there is more scope for U.S. yields to fall (and prices to rise) than there is in the UK. U.S. bonds may therefore be a better source of diversification in the current environment.