UK CPI fell by 0.2% in October, bringing the annualised rate of inflation down from 5.2% to 4.5%. This was the biggest drop in the year-on-year inflation rate since UK CPI data began in 1997. Expectations had been for marginally positive inflation in October, with an annualised rate of 4.8%.

UK interest rate expectations have fallen lower still on this morning’s announcement, and the market is now pricing in a 50/50 chance of rates falling to 1.5% or 1.75% at the end of 2009, although rates are still expected to rise in 2010. Gilts have also continued to rally, with five-year gilt yields breaking new record lows today and 10-year gilt yields falling to 4.05%.

We continue to believe that UK interest rates will go lower than expected, and stay lower for longer. We also strongly believe that gilts will continue to rally as inflation falls sharply over the next year, and we see the potential for double-digit returns for gilts over the next 12 months. UK investment grade corporate bonds should do at least as well as gilts, given that the average UK investment grade corporate bond yields 4.7% more than gilts.

Peter Waller - Investment Director