Gilt Yields Rise as Investors Weigh on UK Labour Market

Following a hotter-than-expected UK labour market print yesterday, yields on the UK 2-year surpassed 4.89% as they hit their highest levels since the GFC.

The sell off came as markets upwardly revised their rate hike expectations from the Bank of England as investors weighed on UK average earnings (including bonuses) rising from 6.1% to 6.5%, some 40bps above expectation. Meanwhile, yields on the UK 10-year (which are less sensitive to expectations around interest rates rose 9bps to 4.43%). Investors also considered the implications of a persistently tight labour market with UK unemployment falling 10bps to 3.8%, against expectations of a 10bps rise. As we looked at yesterday, UK employment is now at record highs rising to 33.9 million following 250,000 more people in work over the three months to May.

With markets assessing the inflationary impact of the data, according to money markets the implied interest rate expectations for the Bank of England is for a terminal rate of around 5.7% by H1 2024. With the base rate currently at 4.5%, this suggests that there could be another 120bps of hikes from the BoE – which if realised would bring borrow rates to their highest level since July 2007. This comes as markets have now fully priced in a 25bps hike when the MPC reconvenes on 22 June.

The latest set of hotter-than-expected data follows Andrew Bailey expressing concern with the UK being in a wage-price spiral. Here, the BoE’s governor emphasised that the tight labour market was still a key driver of inflationary pressure in the UK and stated that “the outlook for inflation further out is more uncertain and depends on the extent of persistence in wage and price setting”. Accordingly, Bailey maintains that the persistence of inflation (which

continues to be in double digits) “reflects second-round effects as the external shocks we have seen interact with the state of the domestic economy. And as headline inflation falls, these second-round effects are unlikely to go away as quickly as they appeared.” As such, he supported the view that further monetary tightening was needed to bring inflation back down to its 2% target.

With interest rate expectations rising, investors rallied towards the pound. Moreover, as the FT writes this morning, “big asset managers are buying up UK government debt again, tempted by the higher yields on offer after a much faster sell-off than in other major bond markets.”

As such, all eyes will be on Threadneedle Street next Thursday where markets are expecting to see the BoE’s thirteenth consecutive rate hike.

US Inflation Eases Ahead of FOMC

As markets weigh on the Fed’s interest rate decision at 1900 today, all eyes were on US inflation data released yesterday afternoon. With US headline inflation falls 90bps to 4% (against expectations of 4.1%), markets gained greater confidence that the FOMC would opt to skip a rate hike. With policy markers looking at month-on-month core inflation (which excluded volatile indexes such as energy & food) the index remained unchanged at 0.4%, though it slowed to 5.3% on an annualised basis. With inflation showing signs of slowing, all eyes turned now turn to the Fed tonight.

In May, the Fed raised their main policy rate to 5.25% marking the tenth consecutive hike which brought borrowing costs to the greatest level since 2007. The Fed minutes expressed that “several participants noted that if the economy evolved along the lines of their current outlooks, then further policy firming after this meeting may not be necessary”. In other words, with inflation falling in line with expectations, given that several policy markers remain “data dependent”, it is expected that the Fed will vote to ‘skip’ a hike today. Nevertheless, with the minutes stating that “many participants focused on the need to retain optionality after this meeting”, some continue to question whether the Fed may raise again later this year.

UK Economy Expands in April

UK GDP figures show that the economy expanded 0.2% in April following a 0.3% contraction recorded in March. This indicates that the size of the UK economy is now 0.3% larger than its pre-pandemic level, though many of the UK’s peers surpassed this milestone months ago. Markets reacted positively to the services sector growing 0.3% over April, following a 0.5% contraction over March as output in consumer-facing services rallied 1%. Nevertheless, the ONS noted that “at the sector level, the main contributors to the monthly decrease were seen in private housing repair and maintenance and private housing new work, which decreased 5.7% and 3.0%, respectively.”

Markets have been buoyed on improved growth forecasts for the UK, with the Bank of England now expecting the economy to grow a quarter-of-a-percent in 2023 and three-quarters-of-a-percent in 2024 (against previous expectations of eight consecutive quarters of economic contraction from Q4 2022 to Q4 2024).