Gilts Jump as CPI Gives BOE Leeway; Pound Weakens to 4-Month Low

U.K. gilts advanced, pushing the yield on two-year securities to the lowest in almost two months, amid speculation slowing inflation will leave room for the Bank of England to maintain its accommodative monetary policy.

U.K. government bonds also rose before the central bank publishes the minutes of its most recent meeting tomorrow, which will reveal how policy makers voted at Governor Mark Carney’s first interest-rate decision. The 10-year gilt yield has climbed more than 35 basis points since Federal Reserve Chairman Ben S. Bernanke said on May 22 that the Fed could cut the pace of its bond purchases if officials saw indications of sustained growth. The pound weakened to a four-month low versus the euro.

“U.K. policy makers have suggested that the recent rise in yields that was influenced by the Fed’s policy was probably unwarranted, and the inflation data today rubber stamped that,” said John Wraith, a fixed-income strategist at Bank of America Corp. in London. “There is much less reason to think monetary conditions should be tightening. Data like this should support short-dated gilts.”

The yield on two-year debt slid five basis points, or 0.05 percentage point, to 0.32 percent at 4:24 p.m. London time, after reaching 0.30 percent, the least since May 24. The 2.75 percent security maturing in January 2015 rose 0.07, or 70 pence per 1,000-pound ($1,513) face amount, to 103.67.

Yield Forecasts

The benchmark 10-year gilt yield dropped eight basis points to 2.27 percent after falling to 2.26 percent, the lowest since June 20. The securities yielded 27 basis points less than similar-maturity Treasuries, the biggest discount since August 2006.

Bank of America forecasts that 10-year gilt yields will be at 2.30 percent by the end of third quarter, before rising to 2.50 percent by the end of the year, according to data compiled by Bloomberg.

U.K. consumer price inflation was 2.9 percent from a year earlier in June, compared with 2.7 percent in the previous month, the Office for National Statistics said. The median forecast of 31 economists in a Bloomberg News survey was 3 percent. Producer prices climbed 2 percent from a year earlier. Analysts in a separate Bloomberg survey predicted a 1.9 percent increase.

Today’s report means Carney, who took over the Bank of England this month, will avoid having to write an open letter to Chancellor of the Exchequer George Osborne about what will be done to control price gains. The central bank’s mandate requires such a letter when inflation deviates more than one percentage point from the 2 percent target.

Inflation Peak

“This could be the peak in CPI for the year, depending on oil price developments,” said Jason Simpson, a fixed-income strategist at Banco Santander SA in London. “The fact it has stayed contained within the Monetary Policy Committee’s allowable range is good news as it will allow policy makers to remain dovish with their forward guidance. This should help underpin the front end of the curve,” he said, referring to shorter-maturity gilts.

The Bank of England signaled on July 4 that it would keep interest rates low for longer than investors had expected. Officials also held their bond-purchase target at 375 billion pounds. Minutes of the policy decision will be published tomorrow and will show whether Carney followed his predecessor, Mervyn King, in voting for more quantitative easing.

Gilts extended their gain after Bank of England policy maker Paul Fisher said the unwinding of stimulus in the U.K. may be “years in the future.”

Exit Strategy

Fisher, who voted for more bond purchases in recent months, told lawmakers in London that the Bank of England’s exit will start with an increase in the benchmark rate, currently 0.5 percent, and the market reaction to that will determine when sales of gilts purchased as part of the quantitative-easing program begin.

“We would only start when we thought we could maintain a program of sales for a good long period,” Fisher said. “We’ve suggested maybe six months’ worth at a time.”

The pound depreciated 0.5 percent to 86.90 pence per euro, after touching 87.07 pence, the weakest level since March 13, as the decline in yields weighed on the currency. Sterling rose 0.2 percent to $1.5123.

The pound dropped 1.3 percent in the past month, according to Bloomberg Correlation-Weighted Indexes, which track 10 developed-nation currencies. The dollar advanced 3 percent and the euro gained 1.3 percent. Sterling underperformed the dollar and the euro amid speculation the new U.K. central-bank chief will favor a loose monetary policy to support growth.

Inflation Expectations

“We expect the pound to weaken further,” said Lee Hardman, a currency strategist at Bank of Tokyo-Mitsubishi UFJ Ltd. in London. “The data may not change the market view that policy makers are willing to be flexible about inflation to support growth.”

The U.K. 10-year break-even rate narrowed three basis points to 3.09 percentage point. The gauge measures market inflation expectations over the lifetime of the debt and is derived from the yield difference between gilts and inflation-protected securities. It’s up from 2.90 percentage points at the end of last month.

Gilts handed investors a loss of 2.7 percent this year through yesterday, according to Bloomberg World Bond Indexes. German bonds declined 0.9 percent and Treasuries fell 2.6 percent, the indexes show.

Inflation-protected gilts outperformed their conventional counterparts, returning 2.6 percent this year through yesterday, according to the Bank of America Merrill Lynch U.K. Inflation-Linked Gilt Index.

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