Notwithstanding the Bank of England doing its best to inject £125 bln into the Gilts market, Gilt yields are backing up along with US Treasury yields and those of German Bunds.

There are basically two schools of thought as to why gilt yields are rising.  The more popular at the moment is that government bond investors are running scared of the deluge of supply of new government debt which is coming the market’s way over the next few years and the yield backup is a way of making room for all this new supply.  The other (less popular) explanation is that markets are anticipating economic recovery and the backup in bond yields simply represents the usual move away from risk-free assets to other more risky securities such as equities and corporate debt.

The second explanation is consistent with the rally in equity markets (with cyclicals such as retailers & mining stocks outperforming defensives such as pharmaceuticals, food processors & utilities) since early March and is also given credence by the synchronised backup in US, UK and German government bond yields.  The Dow has also broken above its 8587 May 8/20 double-top this week and is continuing the rally which started in March and which paused for breath during May (we have had two daily closes above 8587 which have negated the double-top reversal pattern).  The rally in the oil price is also consistent with an expectation of economic recovery and the only market not rallying is credit spreads.  Ordinarily these would be expected to tighten in anticipation of an economic recovery but this time it may simply be the case that banks are still not in a position to lend freely and the SIVs (which would normally be borrowing close to Libor and buying corporate bonds at wide credit spreads) are not in business any more.

Markets are clearly rallying in anticipation of economic recovery which means the rally will only be derailed by clear evidence that the economy is not recovering as per market expectations (i.e. we are still bumping along the bottom or we are going to double-dip back into a W-shaped recession); the catch is this evidence may not show up for quite a while…in the meantime it looks very much like the bears are going to be squeezed hard all summer long.