The UK bond market is being a little more aggressive, with three 0.25% rate cuts fully priced in by June 2009. This is because UK inflation is more under control that in Europe (prices in February were 2.5% higher than they were a year earlier), and because the UK economy is looking very vulnerable (figures from Nationwide show that UK house prices have fallen five months on the trot).
Do the UK and European bond markets’ expectations look reasonable?
If you believe that the effects of the credit crunch will be contained in the US, and that inflationary pressure will remain (or get worse), then yes. But if you buy into our view that economic growth is set to weaken (possibly dramatically), and that inflationary pressure will subside (see Jim’s recent article here), then good quality bonds look rather attractive right now.
*Historically approximately 0.16% has needed to be subtracted from UK and European interest rate futures to arrive at implied interest rate expectations. However, recent distortions in the money market have made interest rate futures analysis a little less reliable, particularly over the very short term. The market may therefore be pricing in slightly more in the way of rate cuts than mentioned above.