UK inflation shock sets gilts up for worst ever start to a year
UK BONDS extended the biggest slide across major markets this year after an unexpected surge in inflation prompted investors to rethink of how much the Bank of England can cut interest rates.
The Bloomberg Sterling Aggregate Bond Index is down over 3 per cent this month, more than any other sovereign market and the worst start to the year on record for the gauge. The rout comes as swap traders abandoned bets on a full quarter-point of cuts earlier this week after the report on UK consumer prices.
The UK isn’t the only place where investors are rethinking their aggressive bets on interest-rate reductions. Traders in the US and Europe have also moderated their expectations. But the turbulence has brought home how vulnerable markets are.
The reaction “will serve as a warning to global markets this quarter,” said Chris Turner, ING’s global head of markets, adding that investors will probably want to wait until the January inflation report in the US before deploying their capital. They “will be wary that the US could suffer something similar,” he said.
Focus in the UK will turn to a syndicated sale of 30-year gilts likely on Tuesday (Jan 23), as well as preliminary January PMI figures due Wednesday. Any weakness in the data could lead traders to rebuild bets on more policy easing. A softer-than-expected reading for retail sales on Friday had already tipped markets in that direction.
“Overall it leaves the BOE very much caught between a rock and a hard place,” said Stuart Cole, chief macro economist at Equiti Capital in London. “At best, the clear path the market was painting for a steady reduction in interest rates this year may have to be re-visited.”
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For some bond traders, it means betting on a flatter curve is starting to pay off again as they position for a later start to interest-rate cuts. The spread between five- and 30-year yields has pared a move since spiking to above 81 basis points earlier this week, the steepest the curve has been since August 2022.
“What we’ve been telling clients on the UK is to position for rate cuts later through a flattener,” said Emmanouil Karimalis, European rates strategist at UBS Investment Bank. He argues that the market is pricing in more cuts in 2024 than warranted, and says most of the easing from the BOE will come in 2025.
Pre-election policy moves may also play into their calculus. Potential fiscal largess in the March budget in the form of tax cuts could persuade policymakers to hold interest-rates steady for longer.
As the trading week drew to a close, markets were pricing 117 basis points of reductions by the end of the year, the equivalent of more than four quarter-point cuts, with odds favouring the first as early as May. At the start of the year, six quarter-point reductions were fully priced in.
Benchmark 10-year yields traded at around 3.9 per cent after reaching 4 per cent earlier in the week, and a far cry from the low of 3.4 per cent touched mid-December.
“The most underestimated risk the market is pricing right now is probably the re-emergence of inflation,” said Grace Peters, head of global investment strategy at JPMorgan Private Bank. BLOOMBERG
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