Peter Schaffrik:
Welcome back to European Markets. My name is Peter Schaffrik, and today is the 21st of May, 2025.
Markets seemingly have calmed down a bit, certainly the 90-day pause in tariffs and some agreements have done a little bit of magic, but clearly they haven't calmed down entirely. Yields are still rising and yield curves are steepening. Today I would like to focus a little bit more on the UK, and I'm glad I'm joined by Cathal Kennedy, RBC's UK economist to suss out what has been driving the UK market lately and what kind of implications or inference it might hold for other markets as well.
So, Cathal, maybe if we start, this morning's inflation numbers, they were quite high, weren't they? So, what's your read of it?
Cathal Kennedy:
Yes, Peter. There was a significant upward surprise in the inflation data released this morning. Now we had expected a jump in inflation in April because we entered a new pricing period for domestic utilities. But I think what was really surprising this morning was the increase in service inflation. Service inflation in April was 5.4%. Now that's significantly ahead of what the Bank of England had it in the monthly policy report.
Now, some of the increase in services was cheated the timing of the Easter holiday, so we had quite a big contribution from transport services. Airfares, sea fares, stuff like that. But nonetheless I think this comes on the back of warnings the Bank of England of late, if you will, that they weren't entirely happy with the path of services disinflation.
Peter Schaffrik:
I think that's very interesting, and I want to come back later to this, but maybe before that, you mentioned the Bank of England here. What is the Bank of England's reaction function given so that the inflation numbers remain seemingly quite elevated?
Cathal Kennedy:
I think of late we've had essentially three events from Bank of England, which they have all had a more hawkish outcome than we expected going into them. The first of them was the February NPC meeting. Second was the May NPC meeting, and the third was the Bank of England's Watchers' Conference, which took place last week.
Now, what was significant for us was that in both the February and May meetings, when perhaps there was opportunity to do so, the bank retained its gradual guidance. So, it kept that guidance in place that it would move gradually in removing the restrictiveness of monetary policy. Then at the Bank of England's Watchers' Conference, we had Clare Lombardelli, the Deputy Governor for Monetary Policy, saying that the picture in services inflation wasn't entirely reassuring. Again, emphasizing that point that the bank isn't entirely happy with how this inflationary process is taking place. I think key to understanding what the Bank of England is at present, is that they're very focused on the supply side of the UK economy rather than the manned conditions in the UK economy.
Peter Schaffrik:
And maybe as a quick follow up, so that supply side or the supply side constraints, they're obviously related to the inflationary pressures that we're seeing and how they manifested in this week's release.
Cathal Kennedy:
Yes. Again, going back to Watchers' Conference, Clare Lombardelli's speech in which she said wage inflation was still too high to being consistent with the Bank of England's inflation target. And that's probably key for the bank going forward. Wage inflation is still around 5.5%, 6% in the UK, and that needs to come down significantly for the bank to feel confident that they can begin to remove the restrictiveness that's currently in place.
Peter Schaffrik:
I want to return to the UK economy in a second, but at at this point, I think it's important to point out we think this focus that Cathal's just mentioned on the supply side of the economy is probably going to be a bit of a blueprint where we will be focusing on in the second part of the year or going forward anyway. Now, when you look across, for instance, to the ECB, the ECB currently doesn't do that. They are over-emphasizing the potential drag on demand. However, there are voices, such as Schnabel for instance or some of the more hawkish members, who do stress exactly these constraints as well.
And, in fact, some speakers of the Fed, most notably in the recent speeches by Powell, he's also stressing that there are lingering inflation concerns that's preventing the Fed from doing something in the here and now. So, we think this is a topic that will concern markets more broadly.
But let's quickly return to the UK. Now, one of the other things that has happened lately is that the UK has struck quite a few agreements, let's say with the EU or most notably also with the US. Is that something that's easing frictions or is there something else in there that we should be taking note of?
Cathal Kennedy:
So, none are transformational, but all help a little bit, shall we say, in terms of outlook for the UK economy. The agreement with the EU was in specific sectors, in defense, in energy, and in agrifood regulations essentially. So, again, easing some of the restrictions or some of the non-tariff barriers that were put in place when the UK left the EU.
The one with the US probably gained, shall we say, most coverage. But it was a surprisingly thin document, just five pages in total, and a trade deal rather than agreement. And here, really this was actually a good win for the UK in that it probably blunted the worst of the impact in the tariffs on some key areas where the UK is exposed to the US, namely cars and pharmaceuticals.
But I think there were some other kind of interesting things in here from I know conversations I've had with you before. One for me was that whereas there was an agreement to reduce tariffs on beef imports from the US, there was no big push from the US for the UK to lower its food standards. And secondly, something that jumped out at me as well, was on the issue of steel, that the UK made an undertaking to, let me just check the exact wording, meet US requirements of the security of the supply chain of steel and aluminum products and the nature of ownership of relevant production sites.
Peter Schaffrik:
Thank you, Cathal. This is highly insightful. I should think there's quite a few things that are relevant beyond just the UK market. I'll pick up on that last point. One of the things that we have been advocating lately is when you look at the demands from the US, particularly as far as security is concerned, we think there is a trade-off here between free trade on the one hand and security on the other. And when trade between partners, particularly such closely related partners such as the US and the UK are concerned, there's promptly a demand to keep key goods, key raw materials, key inputs in-house. And I think that's the reference as far as steel is concerned.
Broader, however, I also think what we're seeing in the UK playing out at the moment, where we have a constrained supply side of the economy that is consistently producing inflationary pressures, and a central bank that's reacting to it, it's probably also something that we should be looking forward when it comes to other central banks as well. Because these constraints on the supply side, they're not necessarily unique to the UK. We have for a long time, for instance, said we think that the ECB is a little bit too dove-ish. And once they've reached, let's say, 2 or 175, they might well be reverting to some of these concerns.
And lastly, when I look at the market as a whole, one of the concerns that we're currently seeing is particularly for long dated securities, where the UK curve has been on the forefront of steepening the curve, rising 30 yields and beyond. That's also related, we think, to these concerns about a constrained supply side of the economy, constrained capacity to grow, inflationary pressures ultimately maybe also spiced up a little bit with concerns about fiscal stability for a lot of countries in the western world.
So, with that, I thank you for watching. Thank you, Cathal, for joining us, and I hope you're going to join us again next time.
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