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Stubbornly high inflation sends bond yields higher

market snapshot

26 May 2023 |
UK inflation fell by less than forecast in April, Wednesday’s data revealed, prompting expectations of further interest rate hikes, and pushing bond yields to their highest levels since October.

Fast reading:

  • UK inflation fell to 8.7% in April – down from 10.1% in March, but still short of the Bank of England’s 8.4% forecast.1
  • Despite falling to single figures for the first time since August 2022, UK inflation still sits significantly above the equivalent US and eurozone rates.
  • Wednesday’s data had a knock-on effect on UK gilt yields, with the yield on two-year gilts hitting 4.4%2 – a rate not seen since Liz Truss’s unvetted ‘mini budget’ in 2022.

The week’s stronger-than-anticipated inflation data comes as food prices in the UK continue to surge, putting pressure on the Bank of England (BoE) to further raise interest rates before the end of the year.

Core inflation, which strips out food and energy prices, continues to rise and remains at close-to-record highs, sparking fears that higher prices could persist.

Orla Garvey, Senior Portfolio Manager for Fixed Income at Federated Hermes Limited, also highlights that service inflation remains elevated, but says the main surprise came in the core goods category.

“We’ve seen in Producer Price Index (PPI) data – and within the input price component of the Purchasing Managers’ Index (PMI) data – that input costs continue to fall quickly. With GBP now generally stronger than Q4 2022, we expect this to continue to feed through to goods prices,” she says.

Drifting away

Inflation in the UK remains stubbornly high against the broader inflationary backdrop, with advanced economies such as the US and the euro area recording lower levels of inflation in April (see Figure 1).

The UK’s current rate compares with 7% in the eurozone and 4.9% in the US3, and sits ahead of only Turkey and Argentina in the G20 Inflation Rate table.

Figure 1: Consumer Price Inflation (CPI) for UK/EU/US

So much for silver, this year it’s paper

In other news, the European Central Bank (ECB) celebrated its 25th anniversary this week, marking a quarter-of-a-century since the institution was formed as a replacement for the European Monetary Institute (EMI) in June 1998.

However, eurozone inflation figures released on Wednesday threatened to overshadow the anniversary, with April’s data showing inflation at 7%4 – down from October’s peak of 10.6%, but still well above the central banks’ target of 2%.

Criticism has been aimed at the ECB’s ‘one-size-fits-all’ monetary policy, as the eurozone’s weakest and most indebted feel the pinch from disproportionately tight conditions.

For Silvia Dall’Angelo, Senior Economist at Federated Hermes Limited, the risk of the central bank doing ‘too much’ feels increasingly likely, putting its reputation further at risk.

“The stakes are high,” she says. “The ECB is probably still the most reputable and effective European institution, so its ability to navigate the current challenges will determine whether that will be the case going forward.”

The ECB is probably still the most reputable and effective European institution, so its ability to navigate the current challenges will determine whether that will be the case going forward.

Dall ‘Angelo notes how the ongoing obstacles faced by the central bank reflect the challenges of the broader European project, adding that the completion of the European institutional framework should help secure the sustainability of the single currency.

 “A one-size-fits-all monetary policy should be balanced by a coordinated fiscal policy within a supranational framework. The banking union and capital market union should be completed, and a pan-European risk-free asset should eventually be introduced. Some progress has been made following the Sovereign Debt Crisis – notably, some crisis-management mechanisms have been put in place – but more work needs to be done, and more political investment is needed,” she says.

Figure 2: 24 years of ECB interest rates / 24 years of the euro

For further macroeconomic insights, please visit our website.  

1 The Financial Times, as at 24 May 2023.

2 The Financial Times, as at 24 May 2023.

3 Trading Economics, May 2023.

4 The Financial Times, as at 24 May 2023.

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