U.K. Government Bond Yield Spreads Widens to Most Since 1996

By Andrew MacAskill

Oct. 18 (Bloomberg) - The difference in yield between two- and 10-year U.K. government bonds widened this week to the most in 12 years on speculation the Bank of England will cut interest rates to limit the severity of the economic slump.

The yield on the two-year note fell by the most in almost two weeks yesterday as traders added to bets policy makers will lower the key rate this year, the short-sterling futures contract showed. The pound headed for a second weekly gain in three against the euro on speculation U.K. policy makers will cut borrowing costs faster than the European Central Bank.

``The steepening trend is being seen everywhere, but is particularly noticeable in gilts,'' said Ciaran O'Hagan, a fixed-income strategist in Paris at Societe Generale SA. ``There are strong reasons for this, given the expectations of rate cuts as the U.K. economy heads down.''

The yield on the two-year gilt rose 8 basis points in the week to 3.59 percent yesterday. The 4.75 percent security due June 2010 dropped 0.21, or 2.1 pounds per 1,000-pound ($1,727) face amount, to 101.76. The yield on the 10-year security climbed 21 basis points to 4.69 percent. Bond yields move inversely to prices.

Traders increased wagers the Bank of England will lower its benchmark rate from 4.5 percent by year-end. The implied yield on the December contract was at 4.71 percent yesterday, down 116 basis points from the end of September.

The spread between two- and 10-year gilts widened to 104 basis points, the most since October 1996. The so-called steeper yield curve suggests investors have become more pessimistic about the outlook for economic growth.

Pound Gains

The pound advanced 1 percent to 77.87 pence, from 78.61 on Oct. 10. Against the dollar, the pound traded at $1.7262, from $1.7043 a week ago, for a gain of 1.3 percent.

``Before, we said that sterling was the weakest currency in town,'' Hans-Guenter Redeker, global head of foreign-exchange strategy at BNP Paribas SA, said in an interview with Bloomberg Television. ``Now the euro is going to be weakest currency.''

Investors should buy the pound against the euro on U.K. rate-reduction expectations, RBC Capital Markets analysts said. Buyers should have a target of 76.10 pence per euro, David Watt, a senior currency strategist in Toronto at RBC, wrote in a research report yesterday. They should exit the trade if the currency falls to 78.90 pence, according to the note.

The pound may strengthen to 70 pence per euro as foreign- exchange markets price in a European slowdown or a recession, a team led by David Simmonds at Royal Bank of Scotland Group Plc in London, wrote in a research note on Oct. 15.

To contact the reporter on this story: Andrew MacAskill in London at amacaskill@bloomberg.net