Not much more needs to be written about the persistence of UK inflation. Idiosyncrasies and/or long-term mismanagement meant the energy shock and skills shortages hit Britain harder than nearly everywhere else —but at least the current direction of travel’s right, right? The worst’s past and we have our best people working on it:
Andrew Bailey sets out why we have raised rates by 0.25% today. The economy is doing better, but inflation is still too high. Raising interest rates is the best way we have of making sure inflation falls and stays low. https://t.co/zsyOpkm1FD pic.twitter.com/QHygx1ZFKr
— Bank of England (@bankofengland) May 11, 2023
I promised to halve inflation. There’s still work to do, but today’s news shows that we’re making progress 👇 pic.twitter.com/eb4TuhQqW0
— Rishi Sunak (@RishiSunak) May 24, 2023
So here’s a thing. Front-end RPI swaps have priced in a second UK inflation spike through the course of next year. And though it’s more shallow than the 2022-23 shock, the market-implied RPI peak of 5 per cent in December 2024 is in sharp contrast to the Bank of England’s target to hit 2 per cent by the start of 2025. Charts below from Barclays:
Moreover, while inflation markets elsewhere did nothing much over the past month, the market response to hot UK data such as this week’s jobs report has been to anticipate a bigger localised second wave.
This is odd not least because inflation swap traders have tended towards being too dovish. Reported UK RPI overshot the rate implied by markets for seven of the last eight readings, and for all of the last five:
A certain type of reader will be jumping to the comment box about now-ish to highlight that RPI includes mortgage interest payments, and that the flip-or-burn nature of UK’s mortgage marketplace causes inflation with a lag. JP Morgan published a deep-dive earlier this month into UK mortgages, showing how the refinancing of fixed-term loans at higher rates will be a two-year problem:
Housing costs are more than a quarter of the RPI by weight. Maybe remortgaging costs are a contributory factor to the 2024 pricing? Not according to Barclays’ rates strategist Jonathan Hill, who just reckons traders are “trying to be too clever by half”:
The reality is that uncertainty is extremely high, and trying to get cute with the ebbs and flows of inflation risk in the near or medium term is inadvisable, to say the least, beyond broadly pricing a deceleration in annual inflation (due largely to base effects and energy deflation) but a stabilization at above-target inflation pricing due to upside risk.
Clearly, it’s quite silly to imagine that derivatives pricing offers an reliable gauge of where inflation is going to be in 18 months’ time. As noted above, the market has been consistently wrong when asked to estimate UK RPI a month out.
Barclays expects the UK inflation curve to flatten — the front end has to rise, the back end has to fall, or some combination of both — but it can’t find a way for clients to profit from its current dislocation. Liquidity is too tight and transaction costs are too high.
Going by that, we probably shouldn’t be reading too much into the UK inflation second-wave implied by pricing — except perhaps that the rates traders with most conviction appear to be expecting the worst.
Further reading:
— No, current gilt yields don’t vindicate Liz Truss, please don’t make us explain this again (FTAV)
