Unemployment nears the 7% threshold – will interest rates rise?

Unemployment fell sharply in the three months to November, to 7.1% – just above the Bank of England’s target of 7% and below analysts’ expectations of 7.3%.

The pound jumped by 0.5% against the euro, hitting a new one-year high of €1.22. At the same time, it strengthened against the dollar to $1.653 – 0.3% higher than before the data was released.

All this because some investors now believe that, with the unemployment rate so close to the central bank’s threshold, Mark Carney’s team will have to raise interest rates much sooner than expected.

“The probability of an interest rate rise in 2014 is increasing. The UK is likely to raise rates before both the European Central Bank and the Federal Reserve”, said ING economist James Knightley, quoted by Bloomberg.

Not so fast, though. Minutes of the Bank of England’s meeting earlier this month reveal that it doesn’t have the slightest intention of increasing rates immediately after the jobless rate goes below the magic number.

“It is likely that the headwinds to growth associated with the aftermath of the financial crisis would persist for some time yet and that inflationary pressures would remain contained. Consequently when the time did come to raise Bank Rate, it would be appropriate to do so only gradually,” the minutes said.

Consumer price inflation hit the central bank’s target of 2% for the first time in four years in December, due mainly to slower increases in food prices.

The stronger pound, which has risen by more than 5% over the past three months against a basket of ten developed-market currencies tracked by Bloomberg, has also helped bring down inflation by making imports cheaper.

No danger of inflation yet

Wages are still increasing much more slowly than inflation – growth in weekly pay in the three months to November was 0.9% – which means consumption is still depressed, keeping a lid on prices.

There was more good news on the fiscal front today, with government borrowing falling, largely in line with the chancellor’s plan. The budget deficit narrowed to £12.1bn in December, £2.1bn less than a year earlier, and compared to a forecast of £14bn by analysts.

The improvement in various economic data all at once ups the game for the Bank of England, making it more difficult to steer the markets in the direction it wants them to go.

If we look at gilts – UK government bonds – we can see that their ten-year yields have been creeping up, currently trading at about 2.88% compared with a 300-year low of 1.43% in August 2012.

This increase in yields – which move inversely to the price – has prompted many strategists to warn that there will be a sell-off in gilts this year, and that their “24-year bull run” is nearing an end, as the FT recently reported.

This could, in turn, lead to a rise in other interest rates – from consumer loans to mortgages – even if the Bank of England’s rate stays the same.

“These factors, together with a rise in sterling, could threaten the nascent recovery,” warned Gautam Batra, managing director and investment strategist at Signia Wealth.

What to do

What can investors do? Get out of UK government bonds, if you haven’t already (although you might want to keep some corporate bonds, as my colleague Phil Oakley recently explained).

Stocks are still a good bet, as at the end of the day a stronger recovery and much lower than anticipated unemployment bode well for the health of companies. Check out Bengt Saelensminde’s ideas here.

The big unknown is UK property. If interest rates rise abruptly, some people could find that their mortgages become increasingly unaffordable. The current property bull-run may well stop.