For much of the year, central banks have told financial markets that inflation is transitory. But what is transitory?
Markets are increasingly pushing back on this notion, specifically in the UK, where two-year retail prices index expectations are above 5%. Last week, the Office for Budget Responsibility forecast that consumer price index inflation would average 4% in 2022. With consumer inflation expectations and wages seemingly on the rise, this presents the Bank of England with a dilemma.
At its September meeting, the bank said: ‘The bank could raise rates while the current quantitative easing [QE] programme is ongoing’. This resulted in short-dated UK government bond yields rising aggressively. Markets were quick to price in a pre-Christmas rate hike, a further hike to 0.5% in February and to 1.25% by the end of 2022.
Having left interest rates unchanged at the November meeting, it seems that the Monetary Policy Committee is still undecided on whether rate hikes are truly the answer to an inflation spike driven by rising energy costs and secondary effects from tight supply chains.
In addition, the committee decided to let the current QE programme run its course to mid-December as planned, despite the market disarray caused by the huge cut in gilt issuance following the latest Budget.
Rate rises
With the end of the year approaching, we expect the market to soon turn its attention to rate rises and the deluge of gilt supply in the next fiscal year.
When base rates reach 0.5%, the bank has stated that it would stop reinvesting the proceeds of any maturing QE bond it owns; leaving the market to digest this issuance on its own for the first time since 2011. Based on current expectations, net supply is likely to exceed the previous record of £162bn.
With elevated inflation, no QE and a central bank that seems reluctant to raise rates quickly, we would expect this to weigh on long-dated bonds and forecast a steeper yield curve in 2022.
Ben Nicholl is a manager on the Royal London government bond fund. Over the past three years, the strategy has returned 8.6%, compared with a peer average of 10.5%
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