Bond markets spooked by inflation (May 08)

The last month has seen the UK’s bond market become much more concerned about the outlook for inflation. In particular, 20 year break-even inflation rates have climbed to levels not seen since the Bank of England was first charged with the task of targeting inflation in 1997. This is not too surprising given that CPI inflation jumped from 2.5% to 3.0% in April and is likely to rise towards 4% in the coming months. Official interest rates in the UK are now likely to remain higher for longer. But the price of this is likely to be a deeper downturn in the real economy and much lower interest rates further ahead. We still think that interest rates will fall to around 3.5% next year.