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UK Inflation Jump Is a Warning to Market Dead Set on Rate Cuts - BLOOMBERG

JANUARY 19, 2024

BY  Constantine Courcoulas and James HiraiBloomberg News


(Bloomberg) -- 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% this month, more than any other sovereign market, in the worst start to the year on record for the gauge. The rout comes as swap traders priced out a full quarter-point of cuts earlier this week, betting on just four such reductions by December, after a report showing UK consumer prices accelerated for the first time in 10 months.

While some of the move was trimmed Friday after retail sales fell more than expected, yields on 10-year bonds are still on track to rise for a fourth-straight week — the longest streak since August.

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 preliminary January PMI figures due Wednesday for signs of how economic activity evolved after the holiday season. Any weakness could lead traders to rebuild bets on more policy easing — at the start of the year, six quarter-point reductions were fully priced in.

“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.”

Focus on Flatteners

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 favoring the first as early as May. 

Benchmark 10-year yields traded at around 3.9% after reaching 4% earlier in the week, and a far cry from the low of 3.4% 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.

--With assistance from Greg Ritchie, Anchalee Worrachate, Alice Atkins and Alice Gledhill.

(Updates to show Bloomberg’s gilt index has registered the biggest loss among major markets this year, adds a new chart.)


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