LONDON: Gilts rallied on Wednesday after a steady fall in share prices throughout the session, but significantly underperformed gains in German government debt as heavy issuance and a temporary end to Bank of England gilt buybacks weighed on prices.
The glut of gilts this week is a consequence of the deterioration in Britain's public finances and growth prospects announced by finance minister George Osborne on Nov. 29, in response to which the UK Debt Management Office added Wednesday's auction to its existing programme.
The 3 billion pound sale of 4 percent 2022 gilts took the total on sale by the DMO this week to 7 billion, the highest weekly auction volume since April.
Wednesday's sale met with reasonable demand, and strategists do not anticipate a problem with the 4 billion pound benchmark 5-year gilt sale on Thursday.
However, the 10-year yield spread between gilts and Bunds widened by about 9 basis points on the day to 17 basis points, and briefly touched its highest level in more than a week at 17.8 basis points .
"The move's been pretty dramatic," said Lloyds strategist Eric Wand. "It's a combination of factors: supply -- there's more to come tomorrow -- and the fact that the BoE is now going to be on a two-and-a-bit week holiday. Year-end conditions are also a useful starting point."
Thin year-end conditions boost volatility, and gilt prices have been supported since October by the BoE's weekly purchases of more than 5 billion pounds of gilts under its quantitative easing programme.
The last buyback this year took place earlier on Wednesday and attracted an unusually small number of offers from banks, in a possible sign of shrinking liquidity as banks attempt to square their books before the end of the year.
LOW YIELDS, UNDERPERFORMANCE
March gilt futures settled 24 ticks up on a day at 115.76, but trailing the equivalent Bund future by a full point. Bunds were boosted by a weak Italian bond sale which reinforced market worries about the euro zone debt crisis.
Nonetheless, gilt futures are remain close to a contract high of 116.00. Ten-year gilt yields also fell back towards the record low yield of 2.07 percent set earlier in the week, dropping 5 basis points on the day to 2.09 percent by 1630 GMT.
By contrast, five-year gilts, which are on sale via auction Thursday, were flat on the day at around 1.07 percent -- and are much further away from the record low yield of 0.812 percent which they set on Dec. 8.
Wand said that investors may look to lock in profits on recent bets that five-year gilts would underperform 10-years by buying the gilts at auction on Thursday and selling gilt futures. Five-year gilts could also attract demand from banks looking for triple-A collateral in which to park funds, even if shorter maturities were usually preferred for this, he added.
There was little market reaction to British unemployment data, which showed a rise in total unemployment to a 17-year high, but an unexpected sharp slowdown in the pace of new unemployment benefit claims.
There is a range of second-tier British data on Thursday, including retail sales, the BoE's quarterly inflation expectations survey and the Confederation of British Industry's monthly industrial orders balance.
Separately, the DMO announced that US broker State Street was stepping down as a primary dealer for gilts with immediate effect, just over two months after becoming a Gilt Edged Market Maker.
State Street blamed tighter financial regulation making the bond market a tougher place to make money, but the move also comes as the European debt crisis increases the risk of being left holding unsold sovereign bonds, and as banks are forced to become more cautious.
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