Like a stroppy teenager with its parent, markets can miss inflation badly when it is gone but sulk when it returns. UK gilts prices slipped on Wednesday’s report of a higher-than-expected 2.5 per cent annual rise in the consumer price index. This news will put pressure on the Bank of England to consider increasing interest rates in the coming year.
Central bankers from the largest economies have preferred to smile away any embarrassing price rises. Just a phase, they have mostly said. Labour markets should be well supplied. Unemployment is still reasonably high at 4.7 per cent. Temporary supply bottlenecks and commodity price surges have caused at least part of the problem.
Inflation hawks point to broadly based inflation signals emanating from everything from building materials to used cars. Too much cash is chasing too few goods, they say.
As a result, the City’s futures markets are pricing in some increases of interest rates by the BoE. Not many expect a policy shift this year. The expected overnight rate benchmark is expected to climb to about 25 basis points by November 2022. As a fraction of one percentage point, that looks tiny. But any change in tone from the central bank is unsettling for bond investors.
The case to panic now is based on momentum. Talk of negative interest rates last year disappeared this year as inflation concerns rose. Five-year inflation expectations, within the UK swaps market, have swelled ever since March 2020. They now predict 2.4 per cent annual CPI growth, about the same as two summers ago.
There is a better case to stay calm. The time curve of inflation expectations over a series of time periods reveals little difference between short and long-term price outlooks. If markets were gravely worried about much higher structural inflation to come, that curve should have a steeper slope, notes RBC.
Demand for steady — if low-yielding gilts — is growing as the UK ages. A fifth of the population are over 65. That jumps to a quarter in 2050. Domestic pension and insurance funds have little choice but to hold sterling bonds. Excluding the BoE’s holdings, local institutions make up about 40 per cent of gilt buyers. Overseas groups, this year very keen on gilts too, account for another 28 per cent.
Markets have thrown a small strop as economic realities become clearer. But bond investors should see through this to emergent maturity beneath.
The Lex team is interested in hearing more from readers. Please give us your view on the outlook for gilts in the comments section below.
Source: Economy - ft.com
