Tomasz Wieladek, Chief European Macro Economist at T. Rowe Price, shares his views on UK Gilts and Euro area as follows:
UK Gilts continue to selloff significantly as financial markets continue to price out Bank of England cuts. At the beginning of the year, the Gilt was a hot commodity. Expectations of declining political and inflation risk premia led bond markets to finally view Gilts favourably again. But Gilts are now selling off more than any other major bond market.
What is going on?
The simple answer is: The UK has had a much greater inflation persistence problem than most other developed markets. While expectations have fallen and the labour market is weakening, elevated inflation continues to be at the forefront of the public debate. That is different than in the Euro area, where inflation has clearly returned to 2% and appears to be sustainable for now. This means that the risk of decoupling inflation expectations is much higher than in the Euro Area. The Bank of England will have to be extra vigilant and keep policy rates elevated to mitigate these risks.
Commentary on Euro Area
Bunds continued to selloff in response to concerns about higher gas prices in Europe’s economies. The timing of the current crisis in the Middle East couldn’t have come at a worse time for Germany. European Gas storage was already running at lower levels than last year. But Germany only has around 20% of its usual reserves, as does France. These will need to be rebuild throughout the year ahead of the Winter. Gas prices will therefore likely stay elevated in Europe even when the crisis subsides.
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What does this mean for the European Central Bank (ECB)?
Germany and the Euro Area will already be experiencing a significant demand driven stimulus as a result of German fiscal expansion. The current events will also lead to a rise in military spending in other countries. The risk that inflation rises in the Euro Area again, especially in light of the persistent services inflation even before the most recent shock, is significant. The German fiscal stimulus could exacerbate these risks by contributing to labour shortages. The ECB would then have to hike again. The ECB’s next move is likely a hike.
