UK bonds wilt after bigger-than-expected jump in CPI

LONDON (Reuters) - British government bond prices fell sharply on Wednesday after an unexpectedly big jump in inflation to its highest in nearly three years, raising questions about whether the Bank of England might trim its stimulus or increase rates sooner than planned.

Interest rate-sensitive two-year British government bond yields rose to a three-week high of 0.129%, up nearly 4 basis points on the day, while benchmark 10-year gilt yields rose by as much as 5 basis points to peak at 0.684%.

British consumer price inflation in June jumped to 2.5% from 2.1% in May, well above the average forecast of 2.2% in a Reuters poll of economists.

The spike in inflation came a day after the United States reported its highest CPI in 13 years at 5.4%.

Both economies are seeing supply-chain bottlenecks as they emerge from the coronavirus pandemic, although the U.S. recovery is more advanced and fuelled by greater government stimulus.

"Central banks will need to start the process of normalising policy sooner than they currently signal," Berenberg Bank economist Kallum Pickering wrote after the data, forecasting a first rate rise by the BoE in August 2022.

BoE Deputy Governor Jon Cunliffe, speaking to CNBC, said the jury was still out on whether the rise in inflation was likely to be persistent and something the BoE needed to act against.

Ten-year gilts underperformed U.S. and German debt. The 10-year yield spread for gilts versus Bunds widened by more than 5 basis points, on track for the sharpest daily underperformance since March 12. Gilts underperformed by more than 7 basis points versus U.S. Treasuries.

Inflation expectations priced into index-linked gilts also rose, pointing to average retail price inflation of 3.4% over the next five years. June RPI came in at 3.9%, up sharply from 3.3% in May.

However Oliver Blackbourn, a fund manager at Janus Henderson Investors, said the British inflation-linked gilt market suggested investors expected UK inflation would be temporary.

"Unlike in the U.S. where the break-even curve is inverted, gilts continue to indicate higher inflation over 10 years than five years, suggesting that markets see less potential for sustained price increases in the UK in the near-term," he said.

The RPI measure used in British index-linked bonds is typically around a percentage point higher than CPI, and is viewed as inaccurate by the UK Statistics Authority, which intends to realign it with CPI https://uksa.statisticsauthority.gov.uk/news/uk-statistics-authority-statement-on-the-future-of-the-rpi in 2030.

(Reporting by David Milliken)