We are currently taking a cautious approach to the gilt market because we believe the market’s continued expectations of further official interest rate reductions after the August cut are too ambitious.
We believe the August cut was largely an insurance move in response to sharp declines in household consumption during 2004 and was understandable in light of the subsequent downward revisions to GDP growth contained in the annual Bank of England ‘Blue Book.’
But the minutes of the Monetary Policy Committee show that support for the cut was marginal and, significantly, the Governor and his two deputies did not favour the reduction.
We believe the market is wrong to look for rate cuts simply because the consumer sector looks weak. Inflation has moved well above the Bank’s 2% target to 2.4% and while oil-intensive sectors of the economy explain much of this increase, underlying inflation, excluding oil, has also turned upward.
This rise complicates the decisions facing the Bank. The market tends to forget that the Bank has a clear mandate to meet an inflation target and the longer we remain above target now, the greater the likelihood that longer-term inflation expectations will rise. In addition, there are signs of improvement in household consumption, mortgage approvals have picked up sharply and the underlying trend in retail sales has strengthened from the disappointing levels seen earlier in the year.
Furthermore, the latest version of the quarterly national accounts saw household consumption revised higher. If this tentative consumer recovery continues and inflation remains above target, the hawks on the MPC are likely to gain the upper hand. Given the market’s expectations for cuts, we therefore believe yields on UK government bonds offer limited value.
By Russell Silberston, fixed income manager at Investec Asset Managemen