RISING CORE INFLATION MEANS BANK OF ENGLAND IS EXPECTED TO KEEP RAISING INTEREST RATES

RISING CORE INFLATION MEANS BANK OF ENGLAND IS EXPECTED TO KEEP RAISING INTEREST RATES

This week more doubt has been cast on the widely held view that central banks are about to bring an end to interest rate hikes. The decline in the UK’s headline rate of inflation was not as big as expected as food, housing and services continue to rise, leaving the Bank of England’s recent upward revision to its inflation forecast in doubt. The rise in core inflation increases the chance that rates in the UK will continue to rise in the very short term. The tone from the US central bank’s most recent interest rate meeting also leaves the door to further rate hikes wide open.

Short-term expectations, including the threat of default on US government debt, have driven yields significantly higher, with the UK not far from the levels that helped end Liz Truss’s term in Downing Street. However, this also raises the chance of a relatively swift reversal and for rates to start coming down in the not too distant future. With central banks increasingly concerned about doing too little to tame inflation, the risk is that rates are pushed too high too quickly until something significant breaks.

UK: STRONG INFLATION UNSETTLES FINANCIAL MARKETS

Headline inflation fell to its lowest level in 12 months as lower energy costs helped the Consumer Prices Index slow to 8.7%, down from 10.1%. The decline was not as big as forecast as food prices continue to rise swiftly and housing costs also increased. Core inflation, excluding volatile energy and food costs, surprised by increasing quite substantially as spending on services continues to push prices higher.

The stronger-than-expected inflation data sparked a big reaction. Investors now expect the Bank of England to raise interest rates even further to bring inflation back under control. Markets now expect base rate to hit 5.5% and this caused government bonds to sell-off and push up bond yields sharply. The yield on shorter-dated bonds jumped dramatically and the yield on 10-year gilts rose above 4.3%, not far from their peak following the disastrous mini- budget last autumn. UK equities also tumbled and the FTSE All Share fell 1.7% as markets reacted to the prospect of higher interest rates slowing the economy.

US: TREASURIES FALL AS GOVERNMENT IS WARNED CREDIT RATING AT RISK

US government bonds have fallen as markets contemplate the US defaulting on its debt. The US government will run out of money at some point in the next few weeks unless Congress agrees to raise the borrowing limit. President Joe Biden and Republican House Speaker Kevin McCarthy have both said there will be no default but the lack of visible progress caused credit rating agency Fitch to put the US government’s AAA credit rating on a negative review due to the short time available to agree a deal.

Typically government bonds with the shortest time to maturity yield less than bonds with a longer duration, but over the last few weeks bonds with one or two months to maturity have tumbled sending their yields above longer-dated bonds. The minutes from the last Federal Reserve interest rate meeting show many rate setters view the next meeting as a chance to pause or skip a rate hike, rather than draw the recent hiking cycle to an end. This has also weighed on US Treasuries and caused the dollar to strengthen.

ENERGY: DOMESTIC BILLS TO FALL AS GAS PRICES CONTINUE TO DECLINE

Consumers will see energy bills start to drop after the regulator reduced its price cap. From July the annual bill for an average home will be capped at £2,074. The previous cap was set at £3,280 but the government’s temporary energy support capped average prices at £2,500 so consumers will see bills drop by around 17%. Gas prices have fallen steadily over the last five months and they are around a tenth of the peak of August last year. However, gas remains far higher than its long-term average. The lower cap is well below the government’s energy price guarantee. The emergency support has so far cost £29.4bn and has contributed to far higher government borrowing in 2023.

Although gas prices have been dropping, electricity producers have continued to generate large profits. SSE this week announced profits from its gas-powered electricity generation are up 90%, while BP and Shell’s recent bumper profits were partly due to profits they made from trading gas.