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Policy-sensitive gilt yield climbs above Bank of England base rate

The gilts market sent a signal on Wednesday that bond investors are leaning towards a UK interest rate rise, after Bank of England governor Mark Carney indicated that he was becoming more upbeat about the country’s economic prospects.

The two-year gilt yield climbed sharply to 0.33 per cent — its highest level since October — before easing back to 0.29 per cent. The jump in yields left the policy sensitive benchmark above the current base rate of 0.25 per cent set by the Bank of England and also buoyed sterling.

The pound set its highest level since the general election earlier this month, rising more than 1 per cent to $1.2956. The 10-year gilt yield rose by four basis points to near 1.20 per cent, before settling down back at 1.16 per cent.

In recent weeks, the two-year gilt has risen from around 0.10 per cent, as Bank officials have debated the merits of nudging the base rate higher, thereby reversing policy stimulus enacted after the UK voted to leave the EU.

Although he sought to qualify his remarks, made at a central banking forum in Portugal, by saying a shift in policy would depend on an improvement in business investment and wages, Mr Carney appeared to sympathise with the views of his hawkish colleagues on the BoE’s Monetary Policy Committee, saying some removal of monetary stimulus was “likely to become necessary”.

Mr Carney’s remarks added to the view that “there is a genuine debate at the heart of the MPC”, said Chris Turner, head of strategy at ING. “BoE policy looks like it is in play, and there’s a bit more to go on this.”

In contrast, Mark Capleton, head of global inflation-linked research at Bank of America Merrill Lynch, said the market was “over-reacting” to Mr Carney’s remarks, which he said were “only mildly more hawkish” than his Mansion House speech earlier this month.

Derek Halpenny at MUFG, agreed. “But there was nothing stopping Carney today from repeating his ‘now is not yet the time’ comment from eight days ago,” he said. “He didn’t do that.”

Nearly a year after the BoE announced its post-Brexit stimulus package, “the conclusion must be that it probably wasn’t needed, and that’s what they are debating”, said Mr Halpenny.

Although UK economic data has been mixed recently, Mr Carney has indicated that rising inflation — thanks to the post-referendum sterling devaluation — is pushing policymakers towards monetary tightening, if the Bank sees evidence of business investment stepping up.

The market was “reassessing the probability of a rate hike in 2017”, with consensus expectations now priced for a rise in the middle of next year, said Mike Amey, sterling portfolios manager at Pimco — by which point “we will have greater clarity on the Brexit negotiations and an understanding of how the economy has weathered the inflation spike”.

Gilts have outperformed other sovereigns this year, reflecting markets’ relatively gloomy outlook for the UK economy and uncertainty over the Brexit negotiations.