After a summer in which global bonds have lost ground for five consecutive weeks, British bond markets are anticipating further rate hikes. But economic data suggests that this view is too pessimistic. Compared to other major economies, the United Kingdom appears to be alone in maintaining a monetary tightening stance. The question is: How long can this position be sustained?
Indicators suggest that inflation is beginning to ease and interest rates elsewhere in the world may be on track to decline. Furthermore, rising unemployment and signs of contraction in the services sector raise questions about the market’s optimistic expectations. A gadget at the Bank of England Museum invites visitors to experience for themselves the frustrating life of a monetary policymaker.
The visitor handles a lever, called ‘Bank interest rate’, and by raising and lowering it he tries to get a metal ball, which represents inflation, to be at the 2% target. The task is impossible. As you move the lever at one end, one mechanism continually changes the height of the other, simulating economic disruptions and confusing your attempts at balance. As soon as the bank interest rate has been raised, it must be lowered again.
Recent U.K. wage data has done nothing to ease concerns that the Bank of England will have to keep raising interest rates if it wants to control inflation, which is why bond markets may remain choppy. All in all, the market could have discounted some of that pessimism.
“To start, the US Treasury market expects at least two cuts over the same period, while the euro zone expects a full cut after the December 2023 peak,” Fidelity experts comment in a recent report. The United Kingdom stands out as the only hawkish country, but the more pessimistic expectations for the Federal Reserve and the European Central Bank (ECB) reflect economic trends that we would not expect to bypass the United Kingdom.
And there are already signs that inflation is falling in the British country, with the consumer price index for July showing a drop from 7.9% year-on-year inflation the previous month to 6.8%, and from the October 2022 peak .11.1%. For its part, the National Statistics Office has published an analysis of the “common trend component”, which excludes volatile prices, such as those of energy and fuel, and which shows that inflation reached a plateau at the end last year and then fell between May and July 2023.
Both series support the current market consensus that UK CPI inflation will spend most of 2024 between 2% and 3%. Then there’s unemployment, which rose from 3.9% in March on a three-month average basis to 4.2% in June. The Bank of England’s arguments for a limited rise in unemployment are based on the idea that businesses will be reluctant to lay off staff, for fear of encountering the same recruitment problems they experienced in the post-pandemic period.
This acceleration in unemployment calls this hypothesis into question, as does the service purchasing directors index for August, which has fallen into contractionary territory. Unemployment now sits just below the break-even rate estimated by the Monetary Policy Committee at 4.25%, four quarters earlier than the MPC thought it would reach.
The interest rate and bonds
Despite these clouds, the market is currently pricing in a real interest rate of around 3.5% next year, assuming a base rate of 6% and the market forecast of 2.5% inflation proving correct. “The last time real rates approached this level was before the global financial crisis, a time when the UK’s debt was much lower than it is today,” describe the analysts at the US manager. The British economy is now much more sensitive to the costs of debt. How high can the profitability of ‘gilt’ go?
Ever since central banks started raising rates, it has been a thankless task to predict the peak of yields. “However, it appears that we are nearing the end of the rally cycle and are becoming more optimistic about gilts…Markets move quickly at turning points, so it may be prudent to start preparing now “they say. This lever of bank rates can be unpredictable.
The consensus predicts that the downward path can still continue, although the path will no longer be as broad. Goldman Sachs pointed out the following in a recent report: “Gilts may still suffer sales in this process of fighting inflation by the United Kingdom, although it is true that there would be less left to find key support.” The bleeding is important and the British country is the first within Europe to have entered recession. The scheme is now more defined, but it may still have some issues. And investors know it.
