Renewed drop in inflation may hit BOE hawks

Edinburgh

BANK of England (BOE) hawks and government bond-market bears may suffer a setback this week should they find inflation, which erodes returns on fixed-income assets, vanished after just one month.

After weeks dominated by Greece's bailout talks, UK gilts may benefit from data due on July 14 that, according to a Bloomberg survey of economists, will show consumer prices stagnated in the 12 months through June.

That will give ammunition to those BOE officials who favour keeping interest rates lower for longer.

Benchmark 10-year gilts fell last week as optimism that Greece was heading for an agreement with its creditors damped demand for haven assets, and the Debt Management Office (DMO) cut its planned gilt sales for this fiscal year less than some banks predicted.

"A renewed drop in inflation will put the hawks on the back foot, signalling that policy can remain on hold for some time yet," said Nick Stamenkovic, a fixed-income strategist at broker RIA Capital Markets Ltd in Edinburgh.

"That means for now the short-end looks pretty well underpinned. But with the flight to quality, the 10-year sector is probably the best place to be at this time," he added.

Benchmark 10-year gilt yields rose eight basis points, or 0.08 percentage point, last week to 2.08 per cent as of the 5pm London close on Friday. The 5 per cent bond due in March 2025 fell 0.88, or £8.80 per £1,000 (S$2,097) face amount, to 125.41.

Two-year gilt yields added one basis point in the week to 0.58 per cent. Shorter-term gilts tend to track what the BOE does with interest rates, while longer maturities are more influenced by the outlook for inflation.

The yield difference, or spread, between two- and 10-year gilts widened to 151 basis points on Friday, having been at 97 basis points as recently as February. The UK inflation rate rose to 0.1 per cent in May, having been at either zero or below in the previous three months. The DMO plans to sell £1.5 billion of index-linked gilts due in March 2026 on July 15.

BOE policy makers led by governor Mark Carney kept the main interest rate at a record-low 0.5 per cent on July 9 and maintained their asset-purchase programme at £375 billion. Markets don't see UK rates rising until August 2016 at the earliest, according to forward contracts based on the sterling overnight index average, or Sonia.

The pound posted its biggest weekly decline versus the euro since June 5, dropping 0.98 per cent to 71.94 pence. Sterling fell for a third week versus the US dollar, sliding 0.4 per cent to US$1.5503. BLOOMBERG