UK Price Shock Sends Bond Yields to Levels Last Seen Under Truss

UK bond yields are back to where they were when Liz Truss was in No. 10 after a shocking inflation report underscored the need for much tighter monetary policy.

(Bloomberg) — UK bond yields are back to where they were when Liz Truss was in No. 10 after a shocking inflation report underscored the need for much tighter monetary policy.

The inflation rate came in higher than all economists forecast — sending wagers on future interest-rate hikes soaring and lifting yields to levels last seen when the former Prime Minister rattled markets with her unvetted mini-budget. 

The rate on 10-year securities now pays a premium of more than 50 basis points over equivalent US notes, around the biggest seen in more than a decade. A key part of the curve inverted the most since February, a sign bond traders are positioning for short-term borrowing costs to remain elevated for longer. 

“It’s a terrible inflation print that really sets the UK apart from other major developed economies,” said Derek Halpenny, head of research, global markets EMEA & international securities at MUFG Bank. “The scale of divergence on the inflation path risks undermining policy credibility.”

The violent market reaction puts a spotlight on the acute problems faced by the UK, which run far deeper than last year’s policy blunders. As other nations make progress in tempering inflation, putting a possible pause in hiking on the table, the UK must also contend with economic fallout from Brexit that’s likely to last for years.

Soon after the data landed, money markets priced in a peak BOE rate as high as 5.5%, suggesting a full percentage point of hikes through the end of the year. 

UK’s Stubbornly High Inflation Fuels Bets for Higher Rates

Gilts slid, with two-year yields set for the largest jump since September, when the UK bond market was still in crisis mode. The yield on 10-year gilts was up 5 basis points at 4.21% after rising as much as 21 basis points earlier in the session to the highest since October. The pound, which might normally strengthen on the prospect of higher rates, slipped 0.1% to $1.24 as of 1:18 p.m. in London.

“Forced rate hikes into weakening UK and global growth is a possible scenario that could also undermine the pound’s performance,” Halpenny said. 

Wednesday’s CPI registered 8.7% in April, exceeding the 8.4% level forecast by the central bank. It’s seen as a key input for Governor Andrew Bailey on when to ease up an inflation fight that’s taken the key rate from 0.1% a year and a half ago to 4.5% now.

Traders now see a quarter-point hike at the next rate meeting on June 22 as a done deal, and are pricing a possible return to larger, half-point increases. That would mark a reversal since the BOE dialed back the pace of its tightening in March.

Bloomberg Economics Says Another Big CPI Shock Leaves BOE With Few Options

In October, gilt yields soared to multi-year highs after the former UK government’s fiscal plans put the country’s financial credibility in question and sent panic ripping through markets. The 10-year yield rose to 4.63% on Oct. 12, the highest since 2008, after pension funds were forced to dump their holdings.

In contrast to that episode — when gilts declined swiftly with the advent of a new prime minister — the selloff is “much more fundamentally justified now,” said Markus Allenspach, head of fixed-income research at Julius Baer. 

He’s expecting the Federal Reserve to start cutting rates as soon as the final quarter of 2023 given core inflation has peaked and credit stress is rising. The Bank of England’s predicament is far trickier, he said, given wage pressures are likely to persist with more strikes pending. 

“No rate cuts from the Bank of England anytime soon,” Allenspach said, who anticipates additional tightening. “With that, the yield spread is likely to widen further.”

(Updates with curve inversion in second paragraph, updates chart.)

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