U.K. Disinflation No Risk as Swap Gap Widens to Record

The widest gap between U.K. and euro-region price expectations in almost 10 years suggests investors are betting Britain will avoid the inflation slump that led the European Central Bank to cut interest rates.

The five-year inflation swap rate, a market gauge of expected consumer-price growth, was 181 basis points higher than that of the 17-nation euro region on Nov. 4, the most since Bloomberg started collecting the information in 2004. Today, it was at 169 basis points, or 1.69 percentage points, versus an average of 80 basis points.

U.K. inflation, which has been above the Bank of England’s 2 percent target since 2009, cooled to the slowest pace in more than a year in October and a core-price measure dropped to the least in four years. That’s more likely to be a blip than the start of a disinflationary trend, according to Societe Generale SA, Morgan Stanley and Pacific Investment Management Co.

“Inflation has printed above target for a long time, and we do not expect a change in that dynamic,” Jorge Garayo, a fixed-income strategist at Societe Generale in London, said in an interview yesterday. “With unemployment falling, our economists see October as a low point in inflation. We don’t buy a U.K. disinflation story.”

Consumer prices rose 2.2 percent in October from a year earlier, the least since September 2012, as auto-fuel costs declined, the Office for National Statistics said Nov. 12. Core inflation slowed to 1.7 percent, the least since September 2009.

Job Creation

Societe Generale forecasts inflation will average 2.8 percent next year as a recovering economy creates jobs. It sees retail-price inflation, the basis for payments on index-linked bonds, accelerating to 3.4 percent from 3.1 percent this year.

Inflation-protected gilts handed investors a 1.6 percent return in 2013, outperforming German and U.S. counterparts that declined 3.1 percent and 7.3 percent, respectively, according to Bank of America Merrill Lynch indexes.

Years after major central banks eased monetary policy to counter the financial and European sovereign debt crises, price pressures remain subdued. About two-thirds of 27 inflation-targeting central banks tracked by Morgan Stanley are still undershooting their goals, or watching prices rise in the lower end of preferred ranges.

Global inflation will be about 2.8 percent this year, the second-lowest since World War II, amid high unemployment in developed nations and slowdowns in emerging markets, according JPMorgan Chase & Co.


The European Central Bank, led by President Mario Draghi, unexpectedly cut its key interest rate in half to a record-low 0.25 percent on Nov. 7 as he warned the region faced the prospect of a “prolonged” period of low inflation. Price growth in the region slumped to a four-year low of 0.7 percent in October compared with its target of just below 2 percent.

The Bank of England kept its benchmark rate at 0.5 percent this month and held its target for bond purchases at 375 billion ($604 billion) pounds. Officials lowered their forecasts this month to show inflation returning to 2 percent in the first quarter of 2015.

“We are taking a defensive stance in the near term to recognize the fact that if inflation in the euro region is going to be very weak, there is a risk that local inflation will come in weaker than expected,” said Mike Amey, a London-based money manager at Pimco. “The expansion of central bank balance sheets does create inflation risk in the longer term.”

Forward Rates

Sterling’s five-year, five-year break-even rate, a measure watched by policy makers for inflation expectations in the five years starting 2018, rose to 3.47 percentage points yesterday after falling to 3.38 percentage points on Nov. 14, the least on a closing basis since August. The average in the past five years was 3.42 percentage points.

The equivalent gauge in the euro area was at 2.15 percentage points, compared with the average 2.42 percentage points in the same period.

The U.K. 10-year break-even rate, derived from the yield difference between regular and index-linked bonds, has risen to 3 percentage points from 2.6 percentage points a year ago. Morgan Stanley says it sees “fair value” for the rate at 3.5 percentage points as inflation expectations are likely to pick up with the economic recovery.

Unemployment in the U.K. dropped to 7.6 percent in the three months to September, the lowest rate since 2009, according to the latest data. Claims for unemployment benefits fell for the 12th month in October.

“Inflation here has largely exceeded 2 percent over the past 10 years and we still think that the risk is more to the upside of the 2-percent target rather than the downside,” said Anton Heese, a co-head of Morgan Stanley interest-rate strategy. “Relative to current levels, there is fundamental value in the 10-year portion of the U.K. index-linked market.”

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