Inflation up, gilts rally ?!

It’s not quite what you might expect. On July 15th, it was announced that UK inflation jumped from 3.3% to 3.8% in June, the highest rate since mid 1992. Expectations had been for 3.6%.But over the course of July, gilts returned +2.7%, making it the strongest month since October 2001. At the beginning of July, there were two 0.25% rate hikes fully priced in to the UK bond market. UK base rates are now expected to remain on hold for the next few years.

Why the rally? Some may argue that it was part technical – after all, gilts experienced the biggest sell off in Q2 since 1994. Also a 15% drop in the oil price in the second half of the month will have helped tame rampant inflationary expectations. However the biggest driver seems to have been a wave of poor economic data. Manufacturing and industrial production data was weak, consumer confidence plunged, HBOS said UK house prices fell 2% in June (the third month in four that prices have fallen by 2% or more) while mortgage approvals dived, suggesting that this housing market crash has much further to go. Industrial trends surveys and business surveys were also very weak, and this is important because the Bank of England pays at least as much attention to these surveys as the ‘official’ economic data – see here for an interesting recent speech by deputy governor Charlie Bean (who was incidentally Richard’s personal tutor at LSE many many moons ago).

The Bank of England’s inflation report on August 13th will provide some further clues as to the MPC’s thinking, although it’s not too controversial to predict that the tone will be on inflation risks being to the upside and growth risks to the downside. We agree with the growth risks being on the downside, but as we’ve argued on this blog recently, we think there is a very real risk that inflation will undershoot the Bank of England’s 2% target in 2009-10. See the chart for our inflation view and the market’s current interest rate expectations (note that our inflationary expectations are of course subject to future revisions, depending upon what happens to wages, energy prices etc)