Rates Spark: UK political risk closely tied to inflation outlook

Articles Rates Spark: UK political risk closely tied to inflation outlook 07:58 Rates Share X LinkedIn E-mail Copy link Share X LinkedIn E-mail Copy link Download Sterling markets remain sensitive to inflation risks, which means any near-term fiscal spending initiatives would have a significant upward impact on GBP rates. The impact of spending further out in the future should be more muted. Meanwhile, US Treasury yields are showing a renewed appetite to test higher; we expect more of this Michiel Tukker and Padhraic Garvey, CFA Sterling rates are still very sensitive to any inflation-inducing shocks Sterling rates to stay sensitive to near term spending plans 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.

And just like that we're back at 4.45% for the 10yr UST 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. Wednesday’s events and market views Eurozone headline inflation is expected to come in at 3% in June, just below the previous 3.2% reading.

Also, for core CPI, the consensus sees a tick lower from 2.6% to 2.5%. Such softer readings would ease the ECB's concerns about second-round effects. From the US, we have ADP and Challenger job numbers, which will both be watched closely for any signs of labour market weakness.

Thereafter, we get the ISM manufacturing indices. Consensus hopes that the prices paid component eases from 82.1 to 77.8, while the headline number should still point at robust growth. The more important non-farm US payrolls number will come in on Thursday.

Meanwhile, we should have many comments to process from central bank speakers as the conference in Sintra will go into the last day. In the afternoon we have a panel discussion with the Fed's Warsh, the ECB's Lagarde and the Bank of England's Bailey. Spain plans a syndicated launch of a new 10y SPGB with an estimated size of €13bn.

The UK will auction £4bn of 7y Gilts. Germany will auction €2bn across 15y and 30y Bunds. The US will auction $28bn of 2y FRNs and $70bn of a new 5y Note.

Rates Daily Content Disclaimer This publication has been prepared by ING solely for information purposes irrespective of a particular user's means, financial situation or investment objectives. The information does not constitute investment recommendation, and nor is it investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. Read more Share X LinkedIn E-mail Copy link Share X LinkedIn E-mail Copy link Download Authors Michiel Tukker Senior UK & Eurozone Rates Strategist Michiel Tukker is a Senior UK & Eurozone Rates Strategist based in London.

Before ING, he worked as a quantitative economist for the Dutch central bank, at BlackRock in its Financial Markets… Padhraic Garvey, CFA Regional Head of Research, Americas Padhraic Garvey is the Regional Head of Research, Americas. He's based in New York. His brief spans both developed and emerging markets and he specialises in global rates and macro relative… In this article Sterling rates to stay sensitive to near term spending plans And just like that we're back at 4.45% for the 10yr UST Wednesday’s events and market views