Markets become more optimistic on recovery

On the whole, financial markets have become increasingly optimistic about the prospects for the UK’s recovery. Interest rate expectations have begun to rise again and equities have rebounded, while inflation expectations in the bond market are now consistent with inflation staying above target for a prolonged period. In our view, however, these movements cannot be justified by the outlook for the economic recovery, which, despite its near-term momentum, still looks set to fade sharply as the fiscal squeeze bites next year. Accordingly, we see potential for rate expectations to fall again, for the poor outlook for profits to pour cold water on the equity rally and for bond yields to edge down again as inflation expectations fade and the Monetary Policy Committee (MPC) resumes quantitative easing (QE) early next year.