Diverging rate paths to favour gilts

Since the Monetary Policy Committee (MPC) is probably only a few months away from starting to raise interest rates, gilt yields are likely to depart from their three decade long downward trend soon. Even so, there is still scope for gilts to outperform US Treasuries. Although yields on 10-year gilts and Treasuries have continued to move in tandem this year, the link should loosen as monetary policy in the two countries begins to differ. Indeed, with the US economy having recovered more since the financial crisis and US fiscal policy set to be less contractionary than UK policy, we think that official interest rates in the US may rise to close to 3% by the end of 2016, but to just 1.5% in the UK. Alongside supporting a decoupling of gilt yields from Treasury yields, this should also push sterling lower against the dollar and hence help to reverse the recent underperformance of UK equities.