UK money rates and yields

The structure of money rates is in part a product of ongoing monetary policy, in part down to supply and demand factors such as liquidity conditions between counterparties, and in part the result of expectations with regard to future policy.

The two key drivers of expectations will likely be UK economic data, and whether the US is entering a phase of QE tapering and both will affect how the market will react to any key changes in monetary policy announced in the next Inflation Report.

Our central expectation is that the recent improvement in UK economic data in terms of both hard data (Q1 GDP) and survey data (PMIs) continues. We also assume that the Fed does start to taper its pace of QE purchases in Q4 this year.

The market will then depend very much on what the Bank of England’s Monetary Policy Committee (BoE’s MPC) policy agenda is set out to be.

If the BoE adopts formal forward guidance, this will likely keep front-end rates anchored out to the five year part of the gilt market. Forward guidance that conditionally keeps rates on hold for a two-to-three-year horizon are largely priced into the front end of the market, but the curve for two to five years would likely flatten, in the event of dovish language from the MPC in the form of explicit forward guidance. But explicit forward guidance while inflation remains above target, and possibly rising, is likely to pressure on gilts beyond five years to maturity such that the curve for bonds between five and ten years to maturity steepens.

As a variation on this approach, the BoE could go for a combination of “open-ended QE” alongside forward guidance. MPC member Fisher has mentioned the idea of a rolling QE programme of £25bn per quarter as one way to extend stimulus. So far, this has not had support within the Committee, but it is possible that once Mr Carney arrives in July, that this idea is adopted.  If there was open-ended  QE  alongside forward  guidance,  we  should expect  the immediate reaction of the market to be positive for gilts, but as the market comes to realise that the MPC is willing to extend QE while inflation risks remain, we should expect this policy mix to turn out to be bad news for the gilt market.

An alternative policy agenda could be for the BoE to provide forward guidance with the indication that the MPC is willing to buy private sector assets (e.g. securitised SME loans). This would provide a very clear indication that the BoE intends to pursue credit easing with the implication that the chances of quantitative easing are reduced.  Under this scenario, we would expect gilt yields to rise, and longer dated issues to bear the brunt of any sell-off.

Of course it is possible that the BoE don’t change policy at all but no introduction of explicit forward guidance would be an implicit indication to the market that the MPC is reluctant to pursue further stimulus. In terms of how the market would read such a move, given that the market is currently expecting the MPC, at the very least, to re-affirm its commitment to maintaining low-rates-for-longer, this would likely be bearish for at least the short end (five year) of the gilt market. But at present this scenario looks unlikely especially after Governor King’s comments at the May Inflation report that markets “….have a lot to look forward to at the next press conference.”

What’s clear is that the policy agenda developed by the BoE to support the UK economy could be distinctly bad news for gilts, particularly at the long end, and with yields so low, quite small shifts in yield imply quite big changes in prices.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla