High Interest Rate Expectations Drove Gilt Trend in Q2

Pub. Date
03 July, 2023
Chart showing UK 10-year government bond yield and decomposition by average current and expected future short-term interest rates and risk premium (per cent)

Main points

  • The 10-year UK government bond (gilt) yield was on an upwards trend during 2022 as a result of the Bank of England’s aggressive monetary tightening cycle. In the first half of 2023, the 10-year gilt yield has fluctuated around 3.5 to 4 per cent, driven by short-term interest rate expectations.
  • Overall, the UK term premium signals that investors are feeling confident about the path of short-term interest rates. However, with inflation proving to be even more persistent than previously thought, the questions of where the Bank Rate may peak, how long the MPC should maintain the Bank Rate at its peak level and, once there, the pace at which to loosen remain contested. If the MPC does not provide clear communication surrounding these issues, we may well see uncertainty return to markets in the coming months
  • In June, policymakers at the Federal Reserve (Fed) opted to maintain the target range for the federal funds rate, while the MPC and European Central Bank hiked their policy rates by 50 and 25 basis points, respectively. The latest data indicate that in May, annual CPI inflation rose by 4.0, 6.1 and 8.7 per cent in the United States, Euro Area and United Kingdom, respectively. With the paths of inflation in these economies now de-coupling following months of rising inflation rates, we may well see divergent monetary tightening cycles. As such, we may start to see differences in market dynamics, particularly between the United States and Unites Kingdom, which had previously been fairly similar.

“Our latest estimates suggest that elevated interest rate expectations continued to drive a stable upwards trend in the 10-year UK government bond (gilt) yield in the second quarter of 2023. These interest rate expectations now exceed 5 per cent, caused by positive surprises in recent CPI data and, in turn, the MPC’s continued monetary tightening. At the same time, the corresponding term premium on the gilt yield has not moved much, signalling that investors are feeling confident about the path of short-term interest rates. This is not entirely surprising given that we have yet to see a meaningful turning point in measures of underlying inflation in the UK. However, when markets believe the Bank Rate has peaked, there may be more uncertainty regarding the path of monetary loosening.”

Paula Bejarano Carbo
Associate Economist