Our 2022 scenario for the UK economy and gilts

Our UK growth forecast for 2022 is on the cautious side, as various obstacles stand in the way of more robust recovery, including the lingering impact of Brexit. We predict 4.5% GDP growth in 2022, below the Bloomberg consensus of 4.9%. We forecast average CPI inflation of 3.9% in 2022, versus the Bloomberg consensus of 3.7%.

Like most other countries, the UK’s growth outlook will be mostly dictated by what happens to the ’excess’ household and corporate savings built up during the covid-19 shock at a time of gradual fiscal and monetary retrenchment. Regarding Brexit, the risk is that the UK’s relationship with the EU continues to deteriorate, especially over the trade status of Northern Ireland. As electricity and fuel prices spiral upwards, the management of the energy transition is another worry, eating into household purchasing power and impacting confidence. 

A sharp deterioration on the virus front is also a risk. While vaccination rates are high, the UK has chosen a more liberal approach to tackling new waves of the coronavirus than other European countries. Longer term, the rise in corporate taxes raises question marks over the country’s friendliness to business, especially if they are the start of a trend. 

We expect one ‘technical’ (15bp) rate hike from the Bank of England (BoE), either this month or in early 2022, followed by two 25bp rate hikes over the course of 2022. But the BoE’s communication has been rather ambivalent lately. The Bank’s traditional reaction function suggests it should hike after the Federal Reserve (which we see raising rates for the first time in June). But the recent anxiety BoE officials have expressed about rising inflation expectations leading to second-round effects means we expect it to move before the Fed. 

UK gilts yields rose strongly across maturities in October on the back of more hawkish comments from the BoE, which compelled market participants to bring forward their expectations for rate hikes. Since then, yields have declined again, due to falling inflation-linked (real) yields stemming from concerns for economic growth.

We expect the 10-year gilt yield to move up again next year—partly in sympathy with US and German government bond yields, partly because the ongoing growth recovery and gradual BoE rate hikes will push real (inflation-linked) yields up (and prices down). Our central scenario (65% probability), is that the 10-year nominal gilt yield will reach 1.3% at end-2022 (up from 0.73% on 7 December 2021). Since higher yields will likely lead to negative total returns, we remain underweight UK government bonds.