Strong demand for UK gilts bring 10-year yield to new record low

The UK gilts strengthened on Wednesday after data showed that service PMI fell more than expected in June. Also, the Bank of England announced in its financial stability report that they will reduce counter cyclical capital buffer to 0.0 percent from 0.5 percent with immediate effect until June 2017 at the least.

The yield on the benchmark 10-year gilts fell nearly 3-1/2 basis points to 0.737 percent, yield on super-long 40-year bonds dipped 3-1/2 basis points to 1.336 percent and the yield on 25-year bonds also slid 3-1/2 basis points to 1.513 percent by 09:30 GMT.

As bearishness grows about the UK economy and expectations pick up about the BoE policy response, Gilts will outperform further on the upside. The Gilt/Bund yield spread, having broken below 100 basis points last week, can easily narrow to 80 basis points multi-week. The Gilt/T-note yield spread, at about -60 basis points, is the narrowest since 2000 (when it troughed at -120 basis points), and could easily drop to -100 basis points during the course of the year.

Interestingly, British’s business minister Sajid Javid called for emergency corporate and income tax cuts to avert a Brexit slump. He further added to set up a growing Britain fund worth of 100 billion pounds and UK’s deficit could rise to 5 percent.

On Tuesday, the fall in the UK June services sector PMI, to 52.3 from 53.5 in May is a weaker outturn than the 52.7 expected by the market and should be interpreted as GBP negative. The fall, combined with the effects of the plunge in the construction sector PMI into deep contraction territory, causes the Markit-calculated composite PMI to dip perceptibly, to 51.8 in Jun (its lowest since Mar 2013), from an upwardly revised 52.9 in May (prev 52.8). The quarterly average of the composite PMI thus falls to 52.7, from 54.2 in Q1 and points towards a growth deceleration in Q3.

The Bank of England (BoE) in its financial stability report concluded that they will reduce counter cyclical capital buffer to 0.0 percent from 0.5 percent with immediate effect until June 2017 at the least and CCB cut will reduce buffer by 5.7 billion pounds and raise bank lending capacity by 150 billion pounds. They further added that FPC is ready to take any further action needed to support financial stability and will give insurers more flexibility to deal with a sharp fall in market interest rates.

Moreover, they also added that the BoE stands ready to take action to ensure capital and liquidity buffers can be drawn on to support lending and the BoE needs to reduce any pressure on firms to restrict supply of credit and provision of financial services. The BoE closely monitoring commercial real-estate, buy-to-let, investor appetite for UK assets and fragile market liquidity and current outlook for financial stability is challenging and some Brexit risks are starting to crystallise, they added.

The BoE Governor Mark Carney said that that BOE will adjustments in commercial real-estate and will tighten credit conditions, there is growing evidence that post-Brexit uncertainty has delayed decisions on investment. Said financial markets have coped well with Brexit volatility and markets are focused on banks returns not resilience. Also said that the central bank can provide substantial FX liquidity if required, sees institutions using liquidity to finance loans and will use the flexibility in UK regulations to the greatest extent possible.

He further added that the BOE will ensure that no bank increases dividends or distributions to shareholders due to BOE rule changes and BOE cannot fully offset Brexit volatility. Future potential of the UK economy is not the gift of the BOE but will be driven by others in the private and public sectors, he added.

Lastly, investors also wait for the FOMC June meeting minutes, which will be published Wednesday, 6 July at 18:00 GMT. Markets will likely pay close attention to this release in an attempt to estimate the Fed's likely next step.

Meanwhile, the FTSE 100 trading down 0.57 percent at 6,508 by 09:30 GMT.