UK April’s Consumer Prices: Markets Abandon Hopes for a Linear Disinflation Path. UK April’s Consumer Prices: Markets Abandon Hopes for a Linear Disinflation Path. UK April’s Consumer Prices: Markets Abandon Hopes for a Linear Disinflation Path.

UK April’s Consumer Prices: Markets Abandon Hopes for a Linear Disinflation Path.

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:


- April’s inflation data show that the Bank of England's is not done fighting inflation. This is likely to result in a slower rate-cutting cycle than the markets had initially anticipated.

- While the BOE may follow the ECB in cutting rates this summer, both central banks will likely remain highly data-dependent. Hence, as the bear-flattening of yield curves concludes, it is probable that a bear-steepening will resume.

- Two-year yields are likely to rise to test 4.71% in the next couple of weeks. Ten-year yields may follow and test resistance again at 4.36%.


Falling gas and electricity prices led to a sharp decline in UK CPI numbers in April, with headline consumer prices increasing by 2.3% year-on-year, down from 3.2% in March. With inflation nearing the Bank of England's 2% target, policymakers might be tempted to consider cutting rates but will remain cautious about celebrating prematurely.

Despite the significant drop in headline consumer prices, the figures still exceeded expectations by 0.2 percentage points. At the same time, Core and Services CPI, remain persistently high at 3.9% and 5.9% respectively. Additionally, the average weekly earnings for the past three months have remained around 6% year-on-year. Thus, markets are quickly recognizing that the Bank of England is unlikely to embark on a swift and aggressive rate-cutting cycle, leaving monetary policy decisions data-dependent.

An ECB June rate cut might enable the BOE to cut rates in summer, too.

The UK and Eurozone economies are closely linked through trade and investment. Economic conditions in the Eurozone can spill over into the UK, influencing the BoE’s policy decisions. For instance, a recession in the Eurozone could dampen UK exports, prompting the BoE to consider rate cuts to support domestic growth. At the same time if the ECB cannot cut rates due to sticky inflation in the Eurozone, the BoE might face pressure to maintain higher rates to prevent capital outflows and currency depreciation.

As we anticipate the ECB to implement its first rate cut on June 6th, there is a high likelihood that the Bank of England will seize the opportunity to follow suit in summer. However, if inflation and wages in the UK remain persistently high, the BoE may be less aggressive in cutting rates compared to the ECB. The data-dependency of both central banks will contribute to rate volatility in the interim. Hence, once the period of bear flattening concludes, it is likely that bear steepening will resume.

Implications for UK Gilts

The reason behind today's bear-flattening of the yield curve is straightforward: markets anticipate that the Bank of England will cut rates less than expected, which could dampen the country's economic growth prospects. As a result, short-term yields are rising faster than long-term yields.

1. High-for-longer means that the bear flattening of the UK gilt curve will continue

The bear-flattening move that we are witnessing to today is likely to continue into June as the two-year Gilts are trading too rich relative to what bond futures are pricing the BOE to cut by the end of the year. The three-month SONIA future is pricing three rate cuts by the end of June 2025. Yet, the two-year Gilt yield at 4.35% is 90bps below the BOE benchmark rate of 5.25%.  As market assess the data dependency of central banks, they will come to the realization that interest rate cuts are not going to be fast and aggressive in the UK this year, pushing 2-year Gilts up to 4.71%.

Source: Bloomberg.

2. Long-term Gilts will remain volatile, but a rally is unlikely.

As the bear-flattening move of the yield curve reaches its limits, the focus shifts to the long end of the curve. For duration to perform well, a fast and aggressive rate-cutting cycle is needed. If this does not materialize, long-term yields are likely to continue trending higher, while the short end of the yield curve remains anchored, resulting in a bear steepening of the yield curve.

Given that inflation remains sticky, and UK economic growth is expected to recover this year, it is unlikely that the upcoming rate-cutting cycle will be aggressive. Consequently, 30-year yields may test resistance at 4.83%. If this resistance is broken, yields could rise towards their October 2023 peak of 5.2%.

Source: Bloomberg.

3. Cash bonds are likely to continue to outperform bond ETFs.

Until inflation remains sticky, bond ETFs are likely to underperform cash bonds due to their exposure to interest rate risk. Holding a cash bond allows an investor to keep the bond until maturity, thereby locking in the yield at the time of purchase. For example, investors who bought 2-year Gilts one year ago at a yield of around 4% per year would realize this yield if held to maturity. In contrast, a short-term Gilt ETF, which continuously buys and sells bonds to maintain its target duration, realized a lower total return of 3.15% over the same period (see table below).

Given the current volatility in the rates market, bond ETFs are expected to continue underperforming cash bonds as they adjust more frequently to changes in interest rates, impacting their prices and returns. 

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