Markets unperturbed by political and interest rate risks

The surprise outcome of the General Election and the MPC’s unexpectedly tight vote on interest rates have triggered only a muted market reaction. Admittedly, trade-weighted sterling fell to its lowest level since March following the election, but that was still 3% above the trough seen last autumn. And the fall was partially reversed as two members of the MPC unexpectedly joined Kristin Forbes in voting for an interest rate hike at the latest meeting. Meanwhile, despite the government’s signals of softer austerity, and the risk that interest rates are raised sooner than expected growing, 10-year gilt yields are lower than they were a month ago. Indeed, markets still don’t expect a rise in interest rates until 2019. However, we think that the economy will remain fairly resilient in the face of political uncertainty and rising inflation in the coming quarters. If we are right, interest rates are likely to rise earlier than markets currently expect, pushing up sterling and gilt yields. Our forecast is for cable to end 2017 at $1.30, while 10-year gilt yields could reach 1.5%.