Central banks far from done despite recession fears

As expected, the Bank of England (BoE) lifted rates by 50bp in August, the first time such an increase has been passed in the quarter century since the bank became operationally independent from government over the setting of monetary policy. This move reflected two fundamental dynamics: the first is that the BoE is conscious of the impact that large increases in interest rates by other central banks will have on sterling at a time when the trade deficit is so high; the second, of course, is that the inflation challenge has become much more acute. The BoE now forecasts that inflation could peak at over 13% in Q4 2022, up from just over 10% in the bank’s May forecast. Subsequently, numbers for both the headline and core rates of inflation for July came in above expectations, leading to speculation that inflation could end up peaking at a higher rate than the latest BoE projections.

There are factors that should bear down on inflation later this year and early next year, especially the recent drop in supply chain disruption, shipping rates and many commodity prices. This will likely lead to a further divergence between the core and headline rate of inflation, which will be driven by troubles in European energy markets. Natural gas futures in the UK for January 2023 are now around 85% higher than their previous peak in the immediate aftermath of the Ukraine crisis, and it is striking just how much more serious the problem is in European markets compared to those in the US. Since February 2020, the natural gas index has risen by roughly 380% compared to over 1,600% in the UK and nearly 2,200% in the EU (see Figure 2.)

The major risk now for UK and other European markets is prolonged externally-driven inflation stoking domestically-led inflation. Conditions in the labour market may exacerbate this risk in the UK: unemployment remains low at 3.8%, inactivity levels – particularly in the 50-64 demographic – remain elevated compared to pre-pandemic levels and pay growth is higher than the BoE is likely to tolerate. Pay settlements, while considerably below inflation, are historically high. According to latest ONS figures, total nominal annual pay growth for the three months to June registered at 5.1% (far higher than market expectations of 4.5%) and the BoE’s Agents’ survey suggests settlements of 6% over the next year – all at a time when productivity is not showing any signs of improvement. According to the Office for National Statistics, average total pay growth for the private sector was 5.9% in April to June 2022, and 1.8% for the public sector. This is by no means pointing to a 1970s wage-price spiral when at one point pay settlements reached 30% and inflation was at 25%, but nonetheless the labour market figures will be weighing on policymakers’ minds. 

One positive development in the last few weeks was the better than expected GDP figures for Q2. While growth registered at -0.1% q-o-q, the figures were weighed down by falling pandemic-related spending and the net loss of one working day due to the Platinum Jubilee celebrations. There were some encouraging increases in private sector activity and business investment has seen a partial rebound, although it remains 6% below its pre-pandemic level. 

There is no doubt that all of this points to further monetary policy tightening, the question is to what extent? Our base case is that the level of interest rates in the UK will rise from 1.75% to 2.75% year end and remain at these levels during 2023, which is below market expectations that currently project rates rising to 3.5% or 3.75% in 2023. Due to better than expected US inflation numbers, it is plausible that the Federal Reserve may not raise rates as high as previously predicted and the ongoing tensions in the Euro area between tackling inflation and reducing bond spreads will likely constrain the European Central Bank, potentially reducing pressure on the BoE to hike rates aggressively. We also feel that the deflationary impact of quantitative tightening and the subdued economic outlook into the medium term will further moderate prospective increases to interest rates in the UK. 

Daniel Mahoney, UK Economist

The Federal Reserve meeting in late July proved to be a rather undramatic event. Despite some excitement around a potential 100bp rise, that hype died pretty quickly and instead the Fed and market were rather aligned in the view the Fed Funds band would be raised by 0.75%, taking the upper band to 2.5%. Incidentally this is where the Fed observes the neutral rate being, defined as the rate which supports the economy whilst keeping inflation constant – but we have known for a while it’s the central bank’s intentions to raise rates into ‘restrictive’ territory, and that more tightening is to come.

The market reaction was rather muted to the decision, rates did retreat somewhat on comments from chair Jay Powell that the pace of hikes may slow in September – indeed the minutes showed subsequently a preference for caution at some point - but at the same time the Fed has also scrapped forward guidance. This means the Fed will be more data dependant, allowing greater flexibility, but for the market this reduces certainty and ensures volatility is here to stay as we head into the autumn.

We saw bigger movements in rates to the downside in the following days after the release of Q2 GDP figures for the US, which printed an annualised decline of 0.9% (markets were expecting a 0.4% increase). This means that the US has entered a technical recession, following the annualised Q1 decline of 1.6%. A technical recession is defined as two consecutive quarters of negative growth. In reality it’s hard to argue that the US is in a true recession, especially when subsequent data for July shows the unemployment rate at 3.5% and payroll growth of 500k+, but nevertheless this hit the market rather hard.

Yields, especially longer dated ones, fell quite considerably as fears of a dismal H2 picked up. US 10-year yields fell close to 2.5%, from a peak of near 3.5% earlier this year – whilst the 2s-10s curve inverted by over 30 basis points - in market talk this screams recession fear.

A recent article from Dutch bank ING noted historical moves at a time when the 10-year yield was close to trading through/below the official benchmark Fed Funds rate, something that looks likely in the coming months. The analysis showed that when 10-year yields trade below the Fed Funds, the peak in the Fed Funds rate was fairly imminent. This will be a problem for the central bank, indicating that their window of opportunity to raise rates is narrowing. What history shows is that one of the opposing forces has to give in, whether it be the Fed or the market.

We are perhaps starting to see this wrestling match taking shape already, given the array of Fed speakers we have heard since the last meeting and the GDP figures talking up the need for further rate hikes, and reiterating the fight against inflation is not over. We saw this from the likes of Mary Daly who stated the Fed is far from done, Charles Evans and James Bullard – the latter even gave a level for the Fed Funds rate at year-end of 3.75%-4%. Early indications suggest the Fed is winning the match so far, with the 10-year yield retracing its steps back towards 3%, giving the Fed some breathing room. 

This sets the scene nicely for the Jackson Hole symposium at the end of August and then the September Fed meeting. July’s inflation miss (8.5% annual vs 8.7% expected and 9.1% previously) has cooled market expectations of another 75bp, and is now weighing slightly towards a 0.5% move – there is a long way to go until the next Fed meeting, with a further employment and inflation dataset to come.

BOE deliver a dovish 50bp hike

The Bank of England followed the Fed and European Central Bank with a jumbo hike of 50bp, meeting the majority of market expectations, and ours on the desk. The moves abroad, and the subsequent impact on the pound as mentioned in July’s Rate Wrap likely played a part in the decision for 8 of the 9 members to vote for 50, but also concerns about inflation expectations in the medium term, remain clear – not helped by a sobering forecast for inflation to peak at 13% later this year.

Take the front-loaded move aside, and the reiteration in the statement that the committee will act “forcefully” should conditions require it to, the decision can be considered another ‘dovish hike’. Markets rightly focused on the forecasts for growth over the next couple of years, with the committee seeing a recession kick-starting in Q4 this year and lasting for five consecutive quarters, whilst also raising forecasts for the unemployment rate and amount of spare capacity in the economy. Like in previous meetings, the committee also cemented its disagreement with market expectations, as implied by the inflation forecasts. Based on the market-implied path for rates (peak at c 3%), the committee now sees inflation in three years’ time at just 0.8%, down from the previous forecast of 1.3% and in fact it’s the lowest ever three-year forecast. 

On that note, the forecasts show inflation below target in three years’ time even in a scenario where rates hold steady at 1.75%. Monetary Policy Committee (MPC) member Dave Ramsden is the first to provide some comments on this, telling Reuters, “I'm certainly not ruling out a situation where when we look at the risk to the economy, having been raising Bank Rate, at some point we then have to start lowering it quite quickly”. Whilst this was in the context of an array of scenarios, upside and downside, this suggests that market expectations of rate cuts to commence next year may have some legs if the BoE recession forecasts proves right.

Understandably market rates fell post-announcement, but like with seemingly every meeting, rates staged a quick comeback – however this time did not exceed pre-meeting levels. The 10-year swap has flirted with levels below 2%, and reached lows not seen since May before the meeting. It took another above-consensus inflation figure in July (10.1% annual rate, 9.8% expected) to again spark rates into life, pushing higher across the curve.

Markets are now fully pricing in a 50bp move in September, and a residual risk of an even bigger move. The curve has inverted further with the peak now seen at 3.75%, up from around 3-3.25% beforehand. Swap rates are back closer to late June levels after the first 75bp hike from the Fed. Quite a reaction to one dataset, perhaps too punchy, but the Bank of England cannot ignore it. The committee will reiterate its concerns around inflation in September, backing another 50bp hike, but it’s unlikely to react drastically to one figure and ultimately remain firm on its pushback against market expectations.

The desk team here expects a 50bp hike to 2.25% in September. In regards to the vote, there is a good chance that it may be unanimous too. Uncertainty stems from new MPC member Swati Dhingra (who replaces hawk Michael Saunders) and how she will vote – her public remarks so far seem to suggest she leans on the dovish side. Dhingra and potentially Silvana Tenreyro, who voted for 25bp in August, could be in the 25bp camp, but ultimately I see the rest of the committee members sticking with their August vote. Beyond that, and without forward guidance, it becomes messy. Politics will be watched, with a budget expected in late September/early October where the extent of fiscal support will be in focus.

Cameron Willard, Capital Markets

All data, unless otherwise stated, is sourced from Bloomberg