UK macro and bonds update

Inflation in the UK has been higher and more persistent than the Bank of England (BoE) expected. Following the large upside surprise in April core CPI, market participants expect inflation to remain around 4% for over the next five years, well above the BoE’s 2% long-term target. 

As a result, the path for BoE rates has been repriced materially higher, with a peak rate close to 5.5%. The two-year UK gilt yield, which is more sensitive to monetary policy, has already moved up to 4.43%, while the 10-year yield was well above its US counterpart at 4.27% (on 30 May). 

Although current market pricing looks elevated to us given our forecast for an economic slowdown and lower headline inflation in H2, we expect that 10-year gilt yields could remain above 4% for some time. As such, we have revised our year-end forecast higher, from 3.3% to 4.0%. 

Finally, UK gilts have become increasingly attractive for foreign investors now that they offer the highest yields in the core sovereign bond space, even once hedging costs are taken into account. But for investors’ confidence to be retained, both the BoE and the UK government need to stay the course in keeping the UK public debt trajectory on a sustainable path.