Aug. 4 (Bloomberg) -- Investors may be too confident that Bank of England Governor Mark Carney will increase interest rates before his U.S. counterpart Janet Yellen.
Two-year gilt yields rose to the highest since 2011 relative to similar-maturity U.S. notes last month as a strengthening U.K. recovery fueled speculation BOE officials might increase the benchmark rate from a record low as early as this year.
The yield difference has since narrowed, and with the American economy springing back to life in the second quarter the spread is set to tighten further, according to strategists at Fathom Consulting and ADM Investor Services International.
“The risk with the Fed is that they are forced to bring their time line forward,” Marc Ostwald at ADM in London said in a July 31 phone interview. “In the U.K., on the other hand, it all looks quite pretty, but scratch below the surface and there are a number of issues.”
BOE officials will probably leave their key rate at a record-low 0.5 percent on Aug. 7, and are due to present new economic forecasts on Aug. 13. While Carney has warned the time to normalize rates is “edging closer,” he also says there is room for more spare capacity to be eroded before beginning the exit from more than five years of emergency stimulus.
In the U.S., where the Federal Reserve led by Yellen is paring its monthly asset purchases, there is a danger that faster-than-forecast growth pushes down unemployment and forces officials to review how long to hold rates at a record low. The economy expanded at a 4 percent annualized rate in the second quarter, indicating a slump at the start of the year was an anomaly, and employers added more than 200,000 jobs for a sixth month in July, the longest such period since 1997.
“There are risks that the Fed will need to start getting more hawkish,” which may drive up U.S. rates, said Michael Riddell, a London-based fund manager at M&G Group Plc, which oversees the equivalent of $417 billion.
Investors are fully pricing in a quarter-point BOE rate increase by February, Sonia forwards show. In the U.S., where the Fed has kept its goal for overnight lending between banks in a range of zero to 0.25 percent since 2008, traders see a 59 percent chance the central bank will raise the target rate to at least 0.5 percent by July 2015, based on futures contracts.
The yield difference between two-year gilts and similar- maturity Treasuries widened to 45 basis points on July 2, the most since August 2011. The spread was 33 basis points on Aug. 1. The five-year gap was about 27 basis points.
According to ADM, indications the Fed might move earlier than July could add as much as 30 basis points to the two-year Treasury yield, currently 0.49 percent, and push the five-year yield above 2 percent from 1.71 percent.
“The risk will be that U.S. short-dated yields would move towards where U.K. ones are, and likewise that U.K. yields may have discounted too much” tightening, Ostwald said.
To be sure, the International Monetary Fund predicts the U.K. will grow almost twice as fast as the U.S. this year and Fed policy makers have pledged to keep rates low for a “considerable time” after ending quantitative easing. By contrast, some BOE officials have said the risks of a rate increase undermining the recovery are diminishing.
“If growth is consistently stronger than the BOE expected, and unemployment continues to fall then they need to set monetary policy for the U.K., not look at what the U.S. is doing,” said Stuart Green, an economist at Banco Santander SA in London, who predicts U.K. rates will rise in November, with the Fed following about six months later.
Weak productivity and heavy personal debts may keep the BOE on hold for longer than markets are anticipating, according to Fathom. Household indebtedness, at about 140 percent of gross disposable income, is higher than in the U.S., and more than two thirds of U.K. mortgages are tied to the BOE benchmark.
“The market is not fully appreciating the fact that the Fed might go before the BOE,” Phil Lachowycz, an economist at Fathom, said in a July 29 interview. “It’s about the ability of the central banks to move rates without it impacting the household sector. The Fed has room to move without derailing the recovery.”
While Fathom predicts the BOE will raise rates in February, with the Fed following in the summer, Lachowycz said he “wouldn’t be surprised” to see the U.S. central bank move in the first quarter. The market is “so clear in what it thinks” that there’s room for the yield difference to narrow, he said.
--With assistance from Neal Armstrong in London.