UBS: Lowering our 10y Gilt yield forecasts

10y Gilt yield now seen at 1.10% end 2017, 1.35% end 2018
Since late January 2017, 10y Gilt yields have fallen by over 40bp. In the process, they have outperformed equivalent maturity US Treasuries by around 15bp, and German Bunds by 30bp. When we last published yield forecasts in November 2016, we deliberately set them below forwards, as our expectations for the UK economy were more pessimistic than the consensus, meaning we perceived a higher likelihood of additional QE over the course of our forecast horizon to the end of 2018. The rally has taken both current and forward yields below our previous targets In our November 2016 forecasts, we predicted that 10y Gilt yields would fall from 1.40% to 1.20% by the end of Q1 2017, before slowly climbing to end 2017 back at 1.40%, and 2018 at 1.65%. At the time, forward yields for the end of this year and next were at 1.54% and 1.70% respectively. They are currently at 1.20% and 1.44%, meaning that without any material alleviation of our concerns for the UK economic outlook, our forecasts have swung from being bullish relative to forwards to being bearish. This does not fit with our underlying narrative, and has precipitated this forecast revision.

Targets for cross market outperformance have been reached, or exceeded 
Our concerns for the UK economic outlook were both absolute and relative compared to other major economies, and our 10y forecasts captured this by anticipating cross market outperformance. We expected the spread against 10y Treasuries to widen from -84bp to -100bp by the end of 2017, and against 10y Bunds to narrow +110bpto +70bp. The first of these targets has already been exceeded, with 10y Gilts currently-116bp v Treasuries, and the second has been reached.

Onset of the real earnings squeeze, and path to EU exit, reinforce UK concerns
We identified two key factors as the expected catalysts of a worsening UK economicperformance. The first was intensifying pressure on the consumer generated by a combination of accelerating inflation and anaemic wages, and since we published our previous forecasts the former (CPI y/y) has accelerated from +0.9% to +2.7% while the latter (whole economy average earnings 3m / y/y) is unchanged at +2.4%. The second was gradual but persistent cooling of investment activity as companies became increasingly focused on the date of the EU exit, which will remain a time of intense uncertainty until, and unless, a comprehensive transitional deal is struck between the UK and the EU.

There are signs in recent data that these headwinds are starting to blow 
While both the squeeze on real earnings and the EU exit process are in their early stages, several indicators increasingly suggest a modest slowdown in some areas of intensify. Even after a better April, retail sales growth is clearly slowing, consumer confidence is softening (especially in forward looking sub-indices), the housing market is losing momentum, and longer term investment plans are cooling, presumably due to the very elevated uncertainty about the environment beyond March 2019. If these signs proliferate and intensify as we strengthening possibility of monetary easing and QE. That would cause front end yields to decline, and conventional Gilts to outperform further against linkers, on asset swap, and cross market.

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