Why UK long-term rates are so low

The UK inflation number came out unchanged today at 3%. That’s a number that marks a significant acceleration in inflation from lows in 2015. Yet, if you look at UK 10-year interest rates, they’re at 1.6%. That’s 140 basis points lower than the headline inflation rate. This is a clear sign that bond markets expect UK base interest rates to move up slowly. Uncertainty surrounding Brexit is a major dampener on expectations.

We are on the backside of an unexpected bout of equity market volatility. So it makes sense to challenge the narrative surrounding the build-up to the selloff. and what the selloff is signalling. The UK story is a good one to help interpret this.

The central bank exerts a dominant influence across its yield curve, not just on the short end. That’s what I have said. That means long-term yield movement largely reflects changing bond market expectations about future central bank rate policy. When yields move up and stay elevated, that’s a sign the market expects future policy rates to climb.

This is what happened in the US before the equity market correction. Markets started pricing in a greater likelihood of 3 or even 4 rate hikes in 2018 and yields climbed. But that’s not what happened in the UK, where real interest rates stay deeply negative. And so, the dichotomy is instructive.

What the UK tells us is that markets expect the UK policy rate to remain low. This is despite the rise in inflation.

A big factor is uncertainty around the UK’s exit from the European Union.

From a US perspective, this means Fed policy matters most for interest rates. Over the short-term, bond markets can send long-term interest rates up. However, if the Fed were to make dovish signals, long-term rates would fall again. So, the way to interpret the recent rise in US interest rates is as the bond market front-running Fed policy action. Markets are anticipating less accommodative monetary policy.

To date, most of the move upward in yields has been about the term premium normalizing. Deflation risk has waned as the global economy has entered a growth spurt. There is no need to flee to safe assets like Treasuries. But, going forward, the question is whether the rise in inflation expectations back to 2% will last.That’s the long-term post-crisis level. A second, more important question is whether the Fed will respond to those expectations.

The UK experience says that inflation expectations matter only if the Fed acts. This is true even if US inflation expectations rise further still — well above 2%. The Bank of England has decided to stand pat again and again, despite inflation rising to 3%. It has even been forced to explain in writing why it has allowed inflation to rise so far. Its letter explained the central bank’s view that it would need to raise rates “earlier” and by a “somewhat greater extent” than last indicated in November. Even so, British 10-year yields remain deeply negative in inflation-adjusted terms. That speaks to the dominance of expectations of central bank policy.

My view on the US is that the Fed has been and probably will be more hawkish than you think. I have long said the Fed is prepared to raise rates three or four times this year. Now the market is coming around to that view. Hence rising yields.

So forget about the government budget deficit. What matters is whether the Fed moves rates up, and how fast.

The consumer price index is the first piece of economic data for the Fed to digest. The data are released Wednesday morning. The forecast is now for a rise 0.3% on a month-over-month basis. That would bring us to 1.9% year-on-year. But, if the numbers are higher, bond yields will likely rise, putting pressure on equity markets.

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