Markets shift too far towards expecting low rates to last

For many years we have argued that UK markets were pricing in too early and too fast a tightening of monetary policy. But now, markets, which currently expect the MPC to leave interest rates on hold for at least another year and to take more than a decade to raise them to 3%, have probably swung too far the other way. We doubt that the recent falls in equity prices will slow the UK’s economic recovery significantly, meaning that inflation still rebounds next year and the MPC raises interest rates in the second quarter. And while there are many headwinds – fiscal austerity and weak eurozone growth to name just two – that will ensure that the MPC raises rates more gradually than in past tightening cycles, those impediments will not last for a decade. Accordingly, we think that 10-year gilt yields could pick up from about 2% at present to 2.5% by the end of next year. Despite this, we think that sterling’s rally will run out of steam soon and expect an even faster tightening of monetary policy in the US than markets currently anticipate to push it down to $1.40 by the end of 2016.