UK bond bears are going into a week of key economic data undaunted.
Swaps trading suggests any respite from UK inflation data Wednesday will be short-lived. While the release is expected to slow into the single digits for the first time in eight months, the market is pricing an average pace that’s double the central bank’s 2% mandate over the next five years. Over three decades it will stay above 3%, the contracts show.
Optimism over the US debt ceiling and banking industry damped demand for the UK’s safest assets last week. Investors offloaded 10-year bonds at the fastest pace in a month, lifting the yield above 4% and raising the premium versus US and German counterparts to the highest since October.
Elevated and protracted inflation expectations mean the weakness is set to linger, according to Royal London Asset Management and Barclays Plc. An improvement in manufacturing sentiment in data due Tuesday will only add to the trend.
“The upside risks to inflation, and risk of latent persistence, could sustain a more hawkish bias from the MPC and upward pressure on front-end real yields,” wrote Jon Hill, inflation strategist at Barclays Plc, who holds a recommendation to sell short-term inflation-linked notes.
Even though their yield — with inflation factored out — is the most-elevated since mid-October, he predicts investors will be able to buy the bonds later to capture an even higher rate.
End of Cycle
In the US, money-market wagers and economists are aligned in predicting the Federal Reserve has all but exhausted its hiking cycle. In the UK, meanwhile, market pricing runs counter to the expectation that the Bank of England will struggle to stick to its guns and keep tightening rates.
Ibrahim Quadri, an economist at Goldman Sachs Group Inc., is not among the doves and says the BOE will likely keep rates “higher for longer.”
He forecasts two more quarter-point hikes that would lift the UK bank rate to 5% by August. That’s earlier than the November terminal rate markets predict. Beyond that, he agrees with wagers showing the key rate on hold until the second quarter of next year.
In testimony to UK lawmakers Thursday, Deputy BOE governor Dave Ramsden highlighted concerns about the “persistence of inflation” and warned that interest rates may have to rise further.
“Everyone thought that the BOE was the most dovish central bank and now they’re having to potentially start shifting the rhetoric,” said Craig Inches, head of rates and cash at Royal London Asset Management. “If you are a global investor, you would be selling UK assets, if you think that rates are going higher.”
To be sure, not everyone is pessimistic on inflation. Megum Muhic, a strategist at RBC, predicts Wednesday’s inflation print will mark a turning point.
“We think the dynamics will begin to swing in the UK’s favour from the April inflation print onwards,” he said. He prefers buying UK bonds that mature in 10 years, while selling their German counterparts to target a narrowing gap in yields.
Just hours after the inflation data come out, investors will get an opportunity to gauge the appetite in bond markets when the government offers £3 billion ($3.7 billion) of 10-year gilts.
A similar offering last month garnered the most demand since 2020.
--With assistance from Naomi Tajitsu.