UK government bonds have rallied strongly in the past few days on the back of a rapidly deteriorating economic outlook. The rally has continued today, after Bank of England governor Mervyn King said yesterday that the UK banking system came the closest to collapse since World War One, that some crisis would have occurred even if Lehman had been saved, and that “the balance of risks to inflation in the medium term [have] shifted decisively to the downside”. The Monetary Policy Committee “will act promptly to ensure that inflation remains on track to meet our target.”

 The UK base rate is currently at 4.5%, and, as at last Wednesday, the UK bond market was pricing in UK base rates of 3.5% by this time next year (which would be level with where they were in mid-2003). As at midday today (22 October), the market is now pricing in a 50% chance of interest rates at 3.25% and 50% of rates at 3% by October 2009. They are then expected to start rising again in 2010.

M&G fixed interest team believes market still not pricing in sufficient rate cuts

 The team continues to believe that the market is being too conservative in its expectations for interest rate cuts, and that rates will stay lower for longer than the market is pricing in. Without aggressive monetary policy action, the UK housing market will continue to fall rapidly. It expects UK inflation to fall below 2% next year, and possibly below 1%. The Bank of England is likely to slash interest rates to avoid deflation as it would increase the future value of debt and therefore be very detrimental to the heavily indebted UK economy, .

 It is impossible to say where interest rates could reach since we do not know how the UK economy will react - if they reach 2.5% and there is no response, they could be cut to 1.5%. If there is still no response, they could potentially fall to zero. And if there is still no response, then the UK would enter the ‘Japan scenario’. But if interest rates reach 2.5% and consumers start spending again, then further rate cuts would not be necessary and the team’s view would change.

 Until we see a stabilising housing market and a resurgent consumer, or until the bond market fully prices in a long series of interest rate cuts, then we will remain long duration across our investment grade funds.