Why Are UK Gilt Yields So High?

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A selloff in UK gilts triggered by the Middle East energy shock sent yields to an 18-year high. The Bank of England signalled a ‘material about-turn’ in monetary policy to dampen an expected surge in inflation, according to Goldman Sachs Global Banking & Markets. The rise in gilt yields may be overdone: The central bank is priced to tighten policy into a weakening economy, further suppressing growth going forward. That said, the BoE is likely to increase rates in April if energy prices don’t fall. Government bond yields have jumped following a shock increase in energy prices that has also increased inflation concerns. That’s especially visible in the UK: the country’s bond yields are the highest among G7 countries. The crisis in the Strait of Hormuz may pose a test for the Bank of England’s (BoE) efforts to contain inflation, says Cosimo Codacci-Pisanelli, a managing director in EMEA Interest Rate Product Sales at Global Banking & Markets. Inflation had been progressing toward the bank’s 2% target before the crisis. “There has been a material about-turn in the policy expectations for what the central bank might do,” says Codacci-Pisanelli. “The Bank of England communication suggests that they prefer to err on the side of caution and tighten policy sooner rather than later in response to that energy price shock to keep inflation expectations in check.” We spoke with Codacci-Pisanelli on March 24 about why the UK has been more vulnerable to the energy shock, the impact of the BoE’s new openness to rate hikes, and his outlook on UK interest rates. Why are UK gilt yields so high? We are dealing with an energy price shock, and what we have learned over the last week is that the scars of 2022, when inflation peaked in the aftermath of the Covid pandemic and the war in Ukraine, are very clear. The Bank of England prefers to err on the side of caution and tighten policy sooner rather than later in response to that energy price shock to keep inflation expectations in check. Why are UK yields so high? Well, the starting point was higher going into the crisis than in Europe—the policy rate in the UK is 3.75% versus 2% in Europe. That is because inflation has taken a bit longer to come down in the UK than it has done in Europe and the US as well. That has meant the central bank has been a little slower to normalize policy rates while inflation was on a downward trajectory and the demand side of the economy was slowing as well. What was the impact of the BoE’s latest policy meeting? The market expected them to signal a pause, but the bank went further and signalled an openness to hiking, and doing so soon. The bank was in the midst of a cutting cycle, and to flip to the possibility of them hiking was a material shift in the rate distribution. We were surprised by the bank’s communication last week. We felt this would have been an opportunity for the MPC to take a victory lap and say, ‘This is why we were slower to cut rates, and now we are in a position to act with more calmness in the face of this supply-side shock.’ They didn’t do that, and instead they opened the door to the possibility of tightening and made implicit references to the next meeting (April), as a possible hike. So it was a material hawkish surprise. And the gilt market reacted. Is the market wrong? Is the selloff overdone? I think the market moved a long way very quickly. Just to give you an idea of how far prices have moved in a short period of time, the market-implied expectation for where Bank rate ends 2026 has sold off 115 basis points since the start of the month. The shift in policy expectations has moved the pricing from roughly 50 basis points of rate cuts to 60 basis points of hikes. Has that gone too far? I think it probably has. Even if the central bank were to react with hikes to the energy shock we’ve had now, given the trajectory of the economy this would probably end up being a policy error of some kind and would definitely have negative growth implicatio

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