U.K. and U.S. economies are at a similar stage of the cycle, but terminal rates are very different.
The acceleration in U.K. wage growth amid low unemployment and dismal productivity growth reminds us of another economy. The similarities with the U.S. are striking, extending to the current level of real GDP growth, consumer spending, consumer confidence, the rate of home price appreciation, and employment growth.
These similarities make one wonder why the OIS curve in the U.K. is so much lower than in the U.S. The BoE’s lift-off date discounted in the market is not far behind that in the U.S. However, the BoE is expected to tighten at a slower pace than the Fed, and to a much lower terminal rate. In 2020, the central bank policy rate is expected to be about a percentage point lower in the U.K. than in the U.S. After adjusting for expected inflation, the gap between the policy rates is expected to be even greater in real terms. The BoE’s real Bank Rate is expected to still be negative in 2030! Our global fixed income strategists see no reason for the long-term equilibrium rates in these two economies to be that far apart.
On a shorter-term horizon, expectations for depressed real rates versus the U.S. over the next few years likely reflect the view that the U.K. economy is much more globally exposed and integrated with the euro area than the U.S. This means that Governor Carney will be more constrained in raising rates, since a stronger pound would undermine the UK economy a lot more than a stronger dollar would damage the U.S. The potential risk of economic fallout in the broader Eurozone if Greece eventually exits the currency union also hangs over the U.K.
Moreover, PM Cameron’s latest budget calls for years of painful belt-tightening beginning in FY2016, creating a strong headwind for growth. Please see the next Insight, (Part II) U.K.: Fiscal And Monetary Policies.