News in Charts: Investors ignore official warnings of higher rates as UK economy stagnates

Our UK Economic Sentiment Indicator (ESI) slipped to 0.1% in May, matching the reading seen in the immediate aftermath of the EU referendum. Back then, sentiment recovered quickly, as both firms and households refocused their attentions on more near-term issues, placing Brexit in the ‘something to worry about later’ category. But with political and economic uncertainty likely to remain elevated, at least until the autumn, we are unlikely to see such a pronounced rebound in confidence this time around.

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Our UK ESI tends to be more stable than the ONS estimate of economic growth, and for that reason we view it as a measure of underlying momentum in the economy. With UK economic growth erratically strong in the first quarter, reportedly buoyed by preparations for a ‘no deal’ Brexit, we expect a much weaker reading in the second quarter. Official monthly data show that UK GDP fell by 0.1% in March and by 0.4% in April. We expect to see a 0.1% contraction in the size of the UK economy in Q2, with risks around this projection to the downside.

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At the meeting that concluded on 20 June, the Bank of England’s Monetary Policy Committee revised down its projection for growth in Q2 from 0.2% to 0.0%. Nevertheless, members continue to warn of higher interest rates. With inflation on target in May, and set to fall through the second half of this year, reflecting the effects of weaker energy prices, investors have rightly taken a different view. A comparison of two-year gilt yields with current Bank Rate provides a simple metric of the direction of change of official interest rates judged likely by market participants. By late June, the two-year yield had dropped some 15 basis points below the policy rate — a clear sign that investors were expecting looser, rather than tighter policy.

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