Rates Spark: UK political risk closely tied to inflation outlook

Inflation remains the biggest threat to gilts, but with oil coming down, Burnham might be given more leeway from markets further out in the future. This is because the political risk in GBP rates is more about the UK’s inflation outlook than sovereign risk. If Labour manages to pull off a fiscal expansion in the near term, then the prospect of reaching the inflation target of 2% could be delayed again. But with oil falling in recent weeks, the inflation outlook should soften next year.

Unfortunately for Burnham, at the moment, sterling rates are still very sensitive to any inflation-inducing shocks. This might be explained by the fact that the Bank of England has not managed to return inflation to target yet. When oil moved well above $100, markets were very quick to price in a significant tightening cycle, much more so than for the ECB. So any large spending initiatives in the near term could expect an immediate market reaction.

Important to note is that a fiscal expansion while inflation is rising is treated differently by markets than during a disinflationary environment. Markets are still pricing in a terminal Bank of England rate around 4%, even above the current bank rate of 3.75%. This should change next year, however, when we expect a more disinflationary environment. This means that the market impact of fiscal plans, such as the currently debated defence spending, depends on the timing of the spending. Near-term spending initiatives should push rates up more than spending further out into the future.

US Treasuries had an excuse to test lower in yields on Tuesday as consumer confidence for June came in weaker than expected (91.2 vs reference at 100). But instead, the market narrative centred on the better-than-expected job openings for May (7.6 million vs 7.3 million anticipated). However, that misses a finer point. It tells us that the bond market is not prepared to go with materially lower long-tenor yields. The 10yr Treasury yield has been trading in sub 4.4% territory in recent days, and looking for an excuse to test lower. It's actually had a few. One of them is the aforementioned consumer confidence reading. Instead, it has chosen to high-tail higher in yield. That gels with the duration of shedding flows seen last week, and it seems to us that more of that has been in play this week.

As a consequence, the 10yr yield finds itself back above 4.4%. It's been driven there by rises in both breakeven inflation and in the real yield. We're okay with both. Breakeven inflation is low enough and should not have material further room to the downside, regardless of what the oil price does. Remember the 10yr breakeven is effectively a 10yr average estimate, and does not have to be slavish to short-term oil price gyrations. Meanwhile, the real yield has also edged higher. We're okay with this too. The real yield should maintain a comfortable 2% handle in light of current growth circumstances, and future ones too, given the rally in risk asset space and the discount that this implies for corporate America.