Investors are rethinking the timing of Bank of England rate cuts in this year.
The Ice Bank of America Index of UK Government Debt has fallen by 3.6% this month, more than twice its US counterpart. This is largely due to an unexpected acceleration of inflation.
The shock added to the uncertainty on global bond markets, as central banks on both sides tried to discourage investors from betting on interest rate reductions this year.
The bond market’s sell-off in January follows one of the biggest bond rallies of recent decades, which lasted for two months. This was fueled by a slowing of inflation and the Federal Reserve’s dovish remarks on interest rates.
William Vaughan said that “the UK gilt market has moved too far and too fast in the last quarter, with significant short-covering being the key driver of the rally.” He added that this week’s surprise inflation figure caught the “now one-way positioned” market by surprise.
While the UK’s annual inflation rate unexpectedly accelerated to 4 per cent in December, economic data has been mixed with retail sales data and wage growth this week both softer than the market had predicted.
Even so, traders on swaps markets bet that the UK is likely to deliver 1.1 percentage point cuts in interest rates this year. This will bring the rate down from its current high of 5.25 percent, which was reached 15 years ago. At the beginning of the year, traders had already priced in 1.73 percent of interest rate cuts.
The BoE’s hawkish bias is likely to continue for some time, given the uncertainty of the data, with UK inflation still the highest among the major economies, and wages growing at around 6.5% year-on-year.
The US economy is resilient, and policymakers are still focused on the inflation target.
The An Ice Bank of America Index of US Treasuries fell by 1.36 percent this month while the German Government Bonds Index — the benchmark of the eurozone– has dropped by 1.91 percent.
Vaughan stated that gilts were more volatile than the other bond markets, “mainly because of the extreme valuation anomalies last year and our extremely high levels of inflation compared to EU and US.”
Some economists believe that the UK’s poor performance this year compared to other major bond markets will not last long.
Jonathan Peterson, economist at Capital Economics said that they expect the UK to be the first developed country where the inflation rate will drop below the target. He estimated that utility price drops will drive the consumer price index down below 2% as early as April.
Capital Economics predicts that the 10-year gilt yield will drop from its current 3.93 percent to 3.25 percent by the end the year.