Markets Skeptical Despite Positive UK Inflation Report

Summary:

1. Increased Odds for BOE Rate Cuts: The market is now pricing in a 50 basis points rate cut by the end of the year, up from 45 bps, driven by recent labor and inflation data. However, a rate cut in September is considered unlikely, with only a 40% probability.

2. Inflation and Labor Data Concerns: While the inflation report and labor data appear positive at first glance, they may not be as strong as they seem. Inflation, though slowing, has pockets of persistence, with core and services CPI well above target. Additionally, changes in benefit eligibility criteria may have artificially inflated the Claimant Count, casting doubt on the true state of the labor market.

3. Divergence Between Gilt and Swap Markets: There is a notable divergence between 2-year Gilt yields, which have dropped significantly, reflecting pessimism about the economic outlook, and the swap market, which hasn't shown the same level of concern. This has led to a widening of the 2-year UK swap spread to 44 basis points.

4. Investment Strategy and Inflation Risks: A cautious buy-and-hold approach is preferable. For 2-year Gilts at 3.5%, yields would need to rise significantly before incurring a loss. However, if inflation remains stickier than expected, markets may resist aggressive BOE rate cuts, potentially impacting long-duration positions.

Odds for the Bank of England (BOE) interest rate cuts by the end of the year have risen slightly following the release of the latest labor and inflation data. Markets are now pricing in 50 basis points (bps) of rate cuts by year-end, up from 45 bps on Monday. Despite inflation slowing down faster than expected and the UK Claimant Count rate rising to levels reminiscent of the Global Financial Crisis (excluding the pandemic spike), markets are not yet anticipating a BOE rate cut in September, with the probability of a September rate cut standing at 40%. Why?

One reason may be the skepticism surrounding the reliability of the current Claimant Count numbers. The Department for Work and Pensions has increased the administrative earnings threshold for full work search conditionality. This policy change means more individuals must meet specific conditions to receive benefits, particularly those earning below the new higher threshold who now need to actively search for work to continue receiving benefits. This adjustment might have artificially inflate the Claimant Count, making it a less reliable indicator of labor market distress.

Additionally, when examining UK inflation data, although the headline, core, and services inflation readings came in below expectations, some troubling signs persist. The Headline Consumer Price Index (CPI) rose from 2% in June to 2.2%. Meanwhile, core and services CPI remain well above the BOE's target, at 3.3% and 5.2% respectively. Concurrently, the UK Retail Price Index (RPI) exceeded expectations, rising to 3.6% from 2.9% in June, reversing the downward trend seen since the first quarter of last year.