The decline in UK government bond yields – to record lows at the long end of the curve – appears to have largely reflected building concerns about growth, rather than deflation. While they have fallen, break-even rates imply that the gilt market expects near-zero inflation to be a fleeting phenomenon. Given that the fall in inflation appears to have entirely reflected lower commodity prices rather than weaker domestic price pressures, we think that markets have made the right judgement. Nonetheless, strengthening growth in real wages and loosening credit constraints should ensure that the economic recovery maintains its strong pace this year. Markets might therefore have gone too far in expecting Bank Rate to remain on hold for another 18 months. As a result, we think that gilt yields are likely to rise gradually during 2015, with 10-year yields climbing to 2% by the end of the year.
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