Inflation surprise prompts 2018's biggest fall in two-year UK yields

British two-year government bond yields suffered their heaviest intra-day fall so far this year after a surprise drop in inflation weakened the Bank of England's case for higher interest rates.
Two-year gilt yields, which are sensitive to short-term interest rate expectations, fell 8 basis points (bps) on the day to a one-month low of 0.808 percent after official data showed inflation dropped to a one-year low of 2.5 percent in March.
Economists polled by Reuters had expected consumer price inflation to hold at 2.7 percent, and average inflation for the quarter as a whole dropped to 2.7 percent versus a Bank of England forecast of 2.9 percent. "An (interest rate) increase in May is still very much on the cards, but the market will reduce its expectations further out," said Neil Birrell, chief investment officer at Premier Asset Management.
Overnight interest rate swaps price in a two-thirds chance that the central bank will raise rates in May to 0.75 percent from 0.5 percent, but the chance of a further rise to 1 percent before the end of the year is now about one in three. Markets had previously seen about a 50 percent chance of rates reaching 1 percent by the end of the year. Two-year gilt yields recorded their biggest intra-day decline since Dec. 1.
Five-year yields were 3 bps lower at 1.15 percent by 1110 GMT and 10-year yields were down 1.5 bps at 1.425 percent. December short sterling interest rate futures touched a one-month high, 4 ticks higher on the day. The Bank of England said in February that it expected interest rates would need to rise slightly sooner and by a somewhat greater extent than previously thought, and last month two of its nine policymakers voted for an immediate rate rise.
However, first-quarter growth is likely to be weak after unusually heavy snow in late February and early March, and figures on Tuesday showed that wages grew less than expected. That said, the unemployment rate hit a four-decade low of 4.2 percent, which is likely to bolster policymakers' view that there is scant spare capacity in the economy.