Rate Expectations

By Alan Higgins, chief investment officer, UK, Coutts.

The UK economy remains one of the strongest within developed markets. Growth in economic activity (gross domestic product) is still on track to top 3% this year, with unemployment continuing to fall steadily and the unemployment rate now standing at 6.4% – its lowest since late 2008. This has brought forward market expectations of when the Bank of England (BoE) is likely to raise interest rates to curb inflationary pressures that are anticipated to build with increasing activity.

However, data last week showed that wage growth remains weak despite the overall strength in the labour market. Average weekly earnings grew by just 0.6% in the three months to June 2014 compared with the same period a year ago. As a result, the BoE halved its forecast of wage growth, and now expects salaries to rise by just 1.25% on average this year.

The tepid outlook for wages, and therefore inflation, has eased market expectations of an imminent rise in UK interest rates, weakening sterling in the process. The Bank is likely to want to see evidence of stronger wage growth before raising interest rates since policymakers will be wary of increasing borrowing costs before households are better able to afford them.

UK government bonds (gilts) have remained firm despite the strong economy, which would be expected to weaken bond prices. Bond yields fall when prices rise and that on the benchmark 10-year gilt has dropped to 2.4%.

Gilt yields have been dragged lower by a combination of record-low yields on German government bonds (forcing investors to seek higher yields elsewhere, including the UK) and continuing geopolitical uncertainty, such as in Ukraine and Iraq.

Nevertheless, we believe bond markets are pricing in an overly-pessimistic outlook. We continue to expect bond yields to rise, and for the UK (and US) to raise interest rates gradually from next year.