U.K.’s Real Yields May Perk Up as Markets Mask Reality: Analysis

U.K.’s real yields have room to rise over the medium to longer term as the rates markets, particularly the front-end, are underpricing the evolving growth and inflation dynamics, Bloomberg strategist Tanvir Sandhu writes.

Nominal yields may soon attempt to play catch up and eventually exceed inflation, with strong Purchasing Managers Indexes this week adding to encouraging signs, along with pickup in wage growth.

After the Bank of England meeting yesterday, Governor Mark Carney said in an interview on Bloomberg Television that Britons should be ready for a rate increase in 2016. The overnight indexed swap curve priced in a full 25 basis points increase in November 2016 at close of markets yesterday after indicating no hike at all next year during intraday trading.

Real rates, the return investors earn after stripping off inflation, should move higher if wage pressures continue the upward trend and the output gap continues to move lower.

The yield on five-year U.K. inflation-indexed bond is now at -1.12 percent vs year-to-date low of -1.51 percent. It has edged up from a trough of -2.63 percent touched in April 2013 but is still way below the historically elevated levels seen before the crisis.

KPMG-REC starting salaries index, a metric Monetary Policy Committee member Ian McCafferty has referred to in the past, far outstrips official wage numbers. This could imply wage pressures are more than current national data.

The premium demanded to bet inflation will rise to 2 percent in two years has moved higher to 128 basis points from a year-to-date low of 74 basis points touched in August.

Any hawkish BOE tone over the medium-term may ignite pound strength, which could push down inflation more relative to nominal yields.

Real yield could also rise via imported disinflation from the Euro-area as well as the emerging market and China.

A risk to the view is that U.K. real rates may drop if markets begin to aggressively factor in potential ECB quantitative easing. In such a scenario, scarcity of European government bonds could lead to spillover of demand to gilts.

The MPC lowered its 2015 and 2016 gross domestic product forecasts -- to 2.7 percent and 2.5 percent -- and raised its 2017 projection to 2.7 percent yesterday. It had projected growth rates of 2.8 percent, 2.6 percent and 2.5 percent respectively in its August Inflation Report.

Note: Tanvir Sandhu is a strategist who writes for Bloomberg. The observations he makes are his own.

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