Sterling markets are looking for a bruise



Ouch. Double-digit inflation has arrived in the UK, with consumer prices rising at an annual rate of 10.1% in July, a 40-year high. This is a game-changer: Britain becomes the first G7 country in the current economic cycle to overcome this psychological hurdle, making it all the more difficult to defend the underlying economy against entrenched inflation expectations. .

Inflation in the UK could ease over the next two months, with petrol prices falling as crude oil dips below $90 a barrel. But the Bank of England will have to look beyond that, as a rise in the energy price cap in October will push annual inflation above 13% by the end of the year. With official rates at only 1.75%, after six consecutive increases, the Monetary Policy Committee is struggling to control the situation as inflation runs at more than five times its target of 2%.

Perhaps more surprising is how off-guard Wednesday’s release, following the release of strong payroll and employment data a day earlier, surprised sleepy pound markets, which had been lulled into summer complacency by the better than expected US CPI for July last week. UK money markets reacted by pricing a 50 basis point hike at the next central bank meeting on September 10, which would repeat this month’s outsized rise rather than back to the more usual swing. a quarter point. Traders expect more decisive action to rein in higher prices, especially as the Old Lady has let the Federal Reserve – which began tightening four months after the BOE – accelerate with more vigorous rate hikes. 75 basis points.

The March 2023 British Pound overnight futures contract signals that official rates will peak at almost 3.75% in just six months, with a sharp upward price revision worth 100 points basic so far this month. Expecting borrowing costs to rise 2 percentage points in such a short period seems like an overreaction, but it illustrates how quickly expectations are changing. Sonia futures volumes were up to 10x the daily average on Wednesday as traders scrambled to reset their positions.

With faster rate hikes expected, the UK government bond yield curve inverted, with two-year yields 12 basis points higher than 10-year levels. This is the largest disparity since 2008, echoing the sharp reversal in the US Treasury market. Yet, short-term gilts only react to events; it is the longer end of the gilt market that fails to properly price lingering inflation risks.

NatWest Group Plc analysts predict a 3% spike in 10-year gilt yields, from 2.3% currently, in part due to the expectation that government bond sales, net of redemptions, will will double next year to over £200 billion ($240). billion). The next two years will require even more borrowing.

The BOE expects a mild but long slump from the fourth quarter, although this could be mitigated by a big fiscal boost from whoever wins the contest to become prime minister, with Liz Truss currently expected to beat Rishi Sunak to become the next occupant of No 10 Downing Street. It’s how this extra expense will be funded that should worry the gilt market, as increased supply is surely on its way. It is the path of least resistance for a beleaguered government facing an acute cost of living crisis.

On Monday, the UK Treasury’s debt management office proposed four additional gilt auctions for the coming quarter. Increased issuance of government securities is expected to become a recurring feature. In addition, there is the double whammy of the BOE which resumes actively selling its gilt holdings in the market from September. This offloading, combined with maturing holdings, will lead to an annual balance sheet reduction of £80 billion, the effects of which are unclear.

Gilts typically hover in a range between higher-yielding US Treasuries and the much lower-yielding European benchmark German Bund. But in the months ahead, UK yields appear destined to gravitate towards their US equivalents, at least until there is hard evidence that inflation is peaking. Unfortunately, by then the economy could well collapse. Sterling traders expect choppy times.

More from Bloomberg Opinion:

BOE leaps $100 billion into the unknown: Marcus Ashworth

The Pros and Cons of Liz Truss: Adrian Wooldridge

• The global economic outlook is as clear as mud: Mark Gilbert

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Market Strategist for Haitong Securities in London.

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