Super-low gilt yields unwarranted by economic outlook

UK markets have taken the meaning of the word “gradual” in the Monetary Policy Committee’s forward guidance on the pace of interest rate rises to a new extreme. Overnight index swap rates imply that markets think that the MPC will wait another year before raising rates and that it will take until 2022 for them to reach just 2%. While there are reasons, such as the re-intensification of the fiscal squeeze, to expect the MPC to raise rates more gradually than in past recoveries, we doubt that the pace of tightening will be quite that slow. The economic recovery still has plenty of momentum and pay growth appears to be picking up in response to the decline in slack in the labour market. What’s more, an even longer period of 0.5% rates would risk stoking asset price bubbles in certain markets. Accordingly, we think that Bank Rate could rise to 1.5% or so by the end of 2016, lifting gilt yields from their super-low levels and enabling sterling to rise a little further against the euro.