Why investors should brace for a Gilt sell-off
Investors should brace for a sell-off in U.K. government bonds, known as Gilts, after the Bank of England (BoE) inadvertently brought forward expectations of an interest rate hike, according to analysts.
BoE Governor Mark Carney said on Wednesday that rates would not rise before Britain's unemployment rate falls to 7 percent, which the Monetary Policy Committee (MPC) forecasts will not happen for three years.
But he also outlined three caveats – known as "knockouts" – to that pledge: above-target inflation; unanchored medium-term inflation expectations and any threat to financial stability. In addition, the BoE's new unemployment target could be met ahead of forecasts, allowing for an earlier rate hike.
The yield on 10-year gilts rose to 2.56 percent - the highest since June 25 - on the back of Carney's comments. The reaction was diametrically opposed to what the BoE would have been hoping for – its plan is aimed at keeping borrowing costs down to stimulate the economy.
Valentin Marinov, head of FX strategy at Citi said the forward guidance was meant to signal further easing in monetary conditions, but "it kind of failed." Instead, investors are now expecting the bank to start slowing its asset purchases sooner than initially thought. They also think rates could rise sooner than they had first thought.
"In reality, they wanted the desired affect to be to stimulate the economy by creating greater clarity, but what happened was the market started pricing in the first hike actually coming in earlier than before the meeting began. Now the question is, what more could they do to bring market rates down for a long time?" he told CNBC.
Under its quantitative easing program, the BoE has been buying gilts with a minimum maturity of three years or longer to lower longer-term borrowing costs. Bond markets have become used to the purchases and are reluctant to see them disappear.
Thushka Maharaj, rates strategist at Credit Suisse said he was bullish on gilts ahead of the inflation report, but now he recommends closing all "outright long positions" following the MPC's emphasis on the "inflation knockout", which he said could "nullify forward guidance".
In particular analysts have advised selling 5-year government bonds, as that is that is where the Bank of England has focused most of its buying, so a winding down of its quantitative easing would affect those the most.
(Read more: BoE's Carney fails to impress with 'Fed 2.0')
Maharaj said the "guidance knock-out" risks still need to be priced into 5 year U.K. government bonds, while Bert Lourenco, fixed income strategist at HSBC said that shorter duration bonds under 3 years duration should provide "modest shelter" for investors.
—By CNBC's Jenny Cosgrave: Follow her on Twitter @jenny_cosgrave