Gilts Asleep at the Inflation Wheel
U.K inflation accelerated modestly in January to 1.8 percent from 1.6 percent, data Tuesday showed. The rate was less than economists had forecast -- a big drag came from the massive 4.2 percent monthly decline in clothing prices. So for the bond markets it's a case of nothing to see here, please move along? Not so fast, as producers' input prices zoomed up to a staggering 20.5 percent yearly pace.
The post-Brexit referendum sterling drop is having a pronounced effect as the U.K. is importing inflation on an industrial scale. The previous time the pound fell out of bed, and the last time input prices rose this sharply, was during the financial crisis in 2008. But the growth outlook this time is different, namely, that we'll have some, and it looks rather decent.
Producers' factory-gate price gains climbed to a 3.5 percent rate, showing that pressures are heading toward retailers. We know that council tax, business rates and utility prices are all set for outsize jumps in the coming months.
So far gilt investors are taking Bank of England Governor Mark Carney at his word, and look to be positioned for officials to keep their key interest rate at a record low as they look through any near-term inflation spike. For bonds it's a bet everyone will hold their nerve as CPI edges up to the 3 percent level we'll see by year-end according to breakeven rates, a gauge of inflation expectations.
The only way real gilt yields of around minus 2 percent make sense is because the central bank has a quantitative easing program. But the BOE's buying is due to end mid-March. Furthermore, 10-year U.K. bond yields are some 115 basis points less than U.S. 10 years, where consumer prices are modestly higher at 2.1 percent. Something has to give and it doesn't look like it will be inflation.
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