UK short-term borrowing costs set for biggest weekly jump since 2009

UK short-term borrowing costs are on track to post the biggest rise this week in more than a decade as investors braced themselves for the Bank of England to take more aggressive action to cool inflation.

Two-year UK government bond yields climbed 0.11 percentage points on Friday to 2.56 per cent, bringing the rise since the end of last week to about half a percentage point — reflecting the strongest fall in price since 2009. Such big moves are unusual in the gilt market, which is typically coveted as a haven during times of broader market tumult.

The surge in two-year yields highlights the shift in market expectations towards a more aggressive tightening in monetary policy by the BoE. Investors have ramped up their outlook for rate rises after hotter than expected inflation data on Wednesday and a report on Friday that pointed to robust British consumer spending.

“This is where good news is bad news,” said Kiran Ganesh, a multi-asset strategist at UBS Global Wealth Management, pointing to how a strong reading on retail sales on Friday added fuel to a sell-off in short-term gilts.

Ganesh said data that open the door to big rate rises also darken the outlook for future economic growth on the premise that sharper increases in borrowing costs will knock the UK economy into a deeper recession.

“Of all the major economies, the UK is closest to falling into the stagflation bucket,” said Ganesh.

The retail sales data showed a month-on-month rise of 0.3 per cent in July, much better than expectations in a Reuters poll for a fall of 0.2 per cent. The data were skewed by a strong rise in online sales due to Amazon’s Prime Day sale, but showed how consumers are still spending even as the cost of living crisis bites.

“We doubt the recent resilience in consumer spending will last for much longer,” said Ruth Gregory, senior UK economist at Capital Economics. “Even so, July’s rise in retail sales provides another reason to think that the Bank of England will raise interest rates by 50 basis points [0.5 percentage points] rather than 25bp at its next policy meeting in September.”

Money markets are now pointing to expectations that the BoE will raise its main interest rate by about 2.2 percentage points by the end of May 2023, up from about 1.6 percentage points at the end of last week.

The selling this week in gilts may have been exacerbated by low trading volumes at the height of the summer holiday season. Still, the action has rippled into other regional government bond markets, adding to upward pressure on short-term yields in Germany.

Traders are also looking towards next week, when central bankers will meet at Jackson Hole, Wyoming, for the Kansas City Federal Reserve’s annual economic symposium at which they will discuss the steps they need to take to rein in rampant inflation. The Jackson Hole summit is often used as a platform for the Fed, the world’s most influential central bank, to make major announcements on its policy stance.

“The narrative over recent weeks has been the idea of the Fed pivoting and inflation coming under control,” said Ganesh. “But Fed members have pushed back against that and perhaps some investors are putting on bets that they’ll sound a more hawkish message at Jackson Hole.”

Elsewhere, European stocks dipped in morning trading on Friday, with the regional Stoxx 600 down 0.7 per cent and the FTSE 100 off by 0.4 per cent. Futures contracts tracking Wall Street’s S&P 500 slid 0.8 per cent, with those following the tech-heavy Nasdaq 100 down 1 per cent.