Fundamental views – UK interest rates

Over the past month, sterling fixed income markets have been on a rollercoaster ride driven by ongoing uncertainty related to Greece and shifting perceptions about the timing of the first rise in UK Bank Rate. UK government bond yields fell sharply into month-end, pulled lower by growing tensions in Greece and an associated flight to safety. At its low in early July, the 10yr yield was down over 30bps from its peak in late June. But yields have since rebounded, with the 10yr benchmark back above 2.0% - little changed on the month. The move higher, which has been reflected across the curve, was driven by (i) growing optimism that a deal in Greece would be struck and (ii) firm domestic economic data and more hawkish comments by various MPC members.

"The flow of hard data over the past month has served to strengthen expectations of a solid recovery in UK GDP growth in Q2 after its Q1 soft patch. Although the latest labour market report showed a drop in the pace of employment growth - a fall of 67k in May relative to the level 3-months ago, this is more a reflection of a shortage of available labour rather than a weakening in labour demand. Notably, earnings growth continued to accelerate. In the three months to May, headline pay growth rose by 3.2% - its strongest pace since April 2010. For now, headline CPI inflation remains subdued, with the annual CPI inflation slipping from 0.1% to 0.0% in June. Market inflation expectations, however, continue to creep higher, with the 5y5y RPI inflation expectation rate having risen by over 50bps since its January low to around 3.4%" says Lloyds Bank.

Looking ahead, the continued absorption of slack and the associated impact on inflation underpin expectations that the, MPC will raise Bank Rate in 2015 Q4. This view has been given added credence by recent comments from Governor Carney who noted that a hike in Bank Rate could be warranted around the turn of the year. This led to a marked shift forwards in the market-implied timing of a first hike in UK Bank Rate by almost a quarter to February 2016. However, that the risks remain tilted towards a slightly later rise. Resilient UK growth, a pickup in inflation and the gradual normalisation of UK & US monetary policy should push yields higher over the medium term. It is expected that, there will be  rise in 10-yr gilt yields to 2.5% by year end and to 3.0% by end 2016, notes Lloyds Bank.