"Not Gilty!" Rule Capital Economics, Forecast Rise in Yields and Pound Sterling

UK government bonds, also known as gilts, should start to yield more courtesy of a stable UK economy and rising inflation expectations says the chief economist at advisory service Capital Economics, Jonathan Loynes.

This is likely to have the knock-on effect of increasing the value of Pound Sterling (versus the Euro, but not the US Dollar) and potentiall bringing about a decline in equities.

The recent fall in gilt yields has been due to a delay in expectations of when the Bank of England (BOE) is likely to raise interest rates.

Sterling had a strong start to 2017 as money markets began to price in the prospect of an interest rate rise in 2017, but subsequent appearances by members of the Bank of England have largely put paid to these expectations.

The Pound has slid as a result.

Persistent economic fears linked to Brexit and a run of softer-than-forecast data releases have also pushed back expectations for that rise which will take the Bank's basic interest rates back above the current record-lows being witnessed.

“The first (25bp) rate hike is not expected to occur until late-2019, a year-and-a half later than was the case a month ago. While there is not an obvious catalyst for such a big revision to markets’ interest rate expectations, this may partly reflect receding concerns about inflation,” says Loynes in a note to clients dated March 7, 2017.

But the economist thinks both interest rates, set by the BOE, and inflation have will actually rise more quickly than is currently being priced in by financial markets.

The expected delay is not really warranted as the economy is likely to do better than expected, and inflation is likely to rise more aggressively than is currently being priced in.

“We think that the recent fall in gilt yields – which appears to partly reflect lower Bank Rate expectations – has been overdone. While economic data has taken a slight turn for the worse, we remain confident that the economy will continue to hold up fairly well and that GDP growth will surprise the consensus on the upside. This would allow the MPC to start normalising interest rates earlier, and at a faster rate, than markets currently anticipate – pushing up gilt yields,” says Loynes.

Since rising interest rates tend to be supportive of the home currency, the current negative outlook has had a weakening effect on Sterling and explains the recent mini-downtrend in the currency.

GBP/EUR Forecast to Rise; GBP/USD Forecast to Fall Further Still

Rising US yields due to Trump’s fiscal stimulus injection are likely to push up yields in the UK as the two tend to correlate.

Yields in the UK, however, will not rise as quickly or as high as in the US leading to a divergence and weakness in the Pound to Dollar exchange rate complex.

The Pound is also grossly overvalued against the Dollar with one recent estimate supplied by J P Morgan placing the real, theoretical, fair-value of the pair at 1.1500 rather than the current 1.2260.  

“Although we think that the Bank of England will hike interest rates sooner and faster than the market expects, we believe that the US Fed will tighten policy more than the markets expect by an even greater amount. As a result, we think that the pound will fall to about $1.20 by the end of 2017,” says Loynes.

The Pound will fare better against the Euro, however, rising to 1.26 by the end of 2018 as Capital thinks that while the market is underestimating growth in the UK it is over-estimating it in the Euro-area.

Risks to the Forecasts

The possibility of a Scottish Referendum on independence causing more stress to the financial system and bringing yields down is a major risk to Capital’s forecast.

Another risk highlighted by commentators is that Brexit negotiations will be more difficult than previously expected.

“The pound could come under renewed pressure once the EU negotiations get underway,” says Loynes.

A further possibility is that Trump’s fiscal stimulus plans will be disappointing and reflation in the US as well as rising US yields do not materialise, causing a downwards knock-on effect in the UK.