May 2019 could go down in the history books as the moment when UK politics really changed – the month where the two dominant political parties lost their way.
Whilst the political risk gauge has certainly increased post-European elections, financial markets have been expecting turmoil for a few weeks now. Sterling has weakened as the probability of a “No deal” Brexit, once thought to be off the table, has started to increase again. Gilt yields have fallen, with the 10-year gilt now yielding less than 1.0%. The yield curve has now started to price in the possibility that the next move in the Bank Rate will be down rather than up, in contrast to the message that the Bank of England have been giving for some time.
At this level of yield, the outlook for fixed income is turning less positive and requires a change in message from the Bank of England to sustain it. The next meeting of the MPC is in June, but they are unlikely to change message at that point unless there is a crisis (economic rather than political) developing. It is more likely that the Bank of England will reassess in August and guide policy at the same time as they release the quarterly inflation report. At that point it appears unlikely that Brexit negotiations or arrangements will be any further forward than they are now. The leadership change within the Conservative party is expected to be completed by mid-July, leaving little time for any further negotiation. The Bank therefore are unlikely to make any changes to their underlying assumption that departure from the EU will be orderly, even if the political developments raise the risk of an alternative scenario.
Another reason why the Bank may change their guidance is if the UK and global economies start to show significant weakness. The UK economy has performed better than expected so far in 2019, but a large part of this performance was to do with economic activity being brought forward ahead of the initial Brexit deadline at the end of March 2019. Some reversal therefore should be expected in the second quarter; with the delay and uncertainty continuing, expectations of the weaker trend in investment are likely to continue from now until the end of the year, and possibly for even longer.
With this in mind, we tend to come down on the side of the Bank of England validating the move lower in gilt yields by changing their message on interest rates to a neutral position from the current hawkish bent. From neutral they then can open up the possibility that if the economic weakness is prolonged, then a cut in bank rate is probable. However, we see this validation to come later in 2019 – most likely in Q4 – thus some consolidation in the gilt market is due in the short term. We expect yields on 10-year gilts to trade in the range of 0.8% to 1.1% over the summer, with the proviso that if it becomes apparent that economic conditions are deteriorating faster than currently expected, then we would expect the Bank of England to act sooner and yields can fall further again.