The tightening has begun!

MPC surprises markets with rate rise to signal new path 

The Monetary Policy Committee (MPC) of the Bank of England once again has surprised markets with its decision to raise interest rates to 0.25%. What sort of an impact this will have on inflation remains unclear, but it is useful in signalling which way policy is going to be moving over the course of 2022, as well as the importance that the Bank attaches to countering inflation. The big question is of course the potential impact of Omicron which has further dampened the economic outlook. While there is currently not an official lockdown, people are reportedly staying away from the office and social gatherings, which amongst other things has impacted the Flash Purchasing Managers Index for December, which plunged from 57.6 to 53.2.

Inflation has become the overriding concern

The interest rate decision has been driven by two factors. Firstly, the inflation data for November saw inflation at 5.1%, a level that the MPC had not expected would be reached until next Spring when tax hikes set for April kick in (April inflation is now expected to be 6%). There remains the expectation that much of the inflation we are experiencing at the moment is transitory (even if that word is used less frequently), and it is true that a good deal of today’s inflation is due to energy prices, which are expected to slowly fade from next summer onwards. That said, there are also growing concerns that inflation is being incorporated into pay settlements more generally and that expectations for a rapid reversion to mean for energy prices is far from certain. Our view is that inflation will fade from May 2022 onwards, but is going to remain above the 2% target throughout the year. The second issue is the broader international monetary policy set by the Fed and the European Central Bank. While we are not looking for a rapid rate rise by the ECB, the Fed has become more hawkish (or less Dovish) and the MPC has clearly felt the need to act, even if its actions are unlikely to be as dramatic as those in the USA. The US Federal Reserve indicated that they looked for interest rates to eventually move towards 2.5%. Given the differing demographics and productivity levels in the UK, our long-term neutral interest rate is almost certainly lower, we expect a further rate rise next summer to 0.5%, any further rates rises beyond 2022 will be slow and gradual.

QE programme is now officially reached its target

The one element of monetary policy tightening that has not been focused upon as closely is the BoE’s Quantitative Easing (QE) programme, which as of December reached its goal of GBP 895bn in assets (GBP 875bn in Gilts, GBP 20bn in corporate bonds). QE’s objective has been to keep longer-term bond prices up and hence yields down. In 2022 the absence of a buyer of last resort is going to tell us just how much actual investor appetite there is for Gilts. For a Government which has shown a marked proclivity for spending, being forced to justify the effectiveness of that spending might come as something of a shock.

Another BoE communication mishap…

Going into the December meetings of the Federal Reserve, European Central Bank and the Bank of England, the outcome of the latter looked arguably the most uncertain. However the discovery of the omicron variant and the subsequent move to “Plan B” in the UK had quashed calls for a December rate hike despite strong labour market figures and further upside surprises in inflation. 

Traders remained nervous as a hike scenario could not be completely ruled out. This was backed up by the Federal Reserve who followed through on recent hawkish pivots at their December 14-15 meeting, announcing an acceleration in asset purchase tapering to $30bn a month from $15bn, whilst also dropping the word “transitory” when talking about inflation in their statement (as chairman Powell pre-announced two weeks prior). The biggest surprise came from the updated forecasts for rate hikes, illustrated by the dot plots, which now point to three interest rate hikes in 2022 (0.25% each) from one previously. Powell and co are seemingly not too worried about Omicron, seeing it as a short term blip, and inflation concerns carry more weight at this stage.

The European Central remain behind the curve, despite announcing a small taper of asset purchases, the expansionary nature of their policy remains intact. Asset purchases will continue under an open-ended asset purchase programme (APP) whilst reinvestments under the emergency programme, PEPP, will now end a year later in 2024. Longer term inflation forecasts remain below, but closer to the 2% target, all in all this points to interest rate increases likely to only be in the pipeline from 2023 onwards.

The Bank of England decided to follow the Fed’s lead, surprising markets by opting to raise interest rates to 0.25% from 0.1%. The committee voted 8-1 in favour of a hike, with only Silvana Tenreyro dissenting, the statement referred to concerns around inflation which they see reaching 6% in April. The statement noted that keeping interest rates on hold risked fuelling higher inflation expectations which may become de-anchored.

Naturally, in typical knee-jerk fashion, swap rates jumped on the announcement as shown in the chart below. Again, the surprise comes down to the vague communication provided by the committee members in the lead up to this meeting – despite the fact recent data probably justifies a hike, all the talk on the wires, whether it be from the likes of Pill or Saunders, seemed to paint an uncertain committee too. Swap rates jumped 0.05-0.06% across the curve, but remain way off highs seen prior to the November meeting. Some clients have took advantage of the move lower in rates, locking in hedging at levels below 1% for long periods, but that may prove tougher to achieve now before year-end.

The gap between 3 and 5 year rates and 10 year rates has in fact increased (further curve inversion) post decision, signalling that the market is still concerned that we could see the central bank having to backtrack its policy tightening further down the line as it hinders growth. This is not just a challenge for the UK, but all developed economies – in the latest Bank of America monthly survey, 46% of credit investors see the potential for a policy mistake as a top concern.

Looking at the statement in greater detail, the BoE like the Fed are overlooking the short term impact of the Omicron variant, and instead focusing on the medium term inflation prospects. Referring to the November meeting, the committee judged that a hike was warranted given the continuous tightening of the labour market, confirmed by the official release of the October figures. However they still note two way risks to inflation in the medium term, and have reiterated that only “modest” tightening is likely to be necessary. So even with December’s hike, the market consensus of rates rising to 1% by the end of next year still seems a bit out of line with the BoE’s thoughts – but nothing can be ruled out with the central bank’s track record on communique.

Gas prices back in focus

We zoomed in on gas prices back in the autumn where prices were rising exponentially before calming somewhat, but the underlying concerns have not disappeared, and in recent days have indeed heightened again. The focus here is on Russia who are seemingly reluctant to increase supply into Germany via Eastern Europe through the Yamal pipeline, due to ongoing tensions with Ukraine and the West over a build-up of Russian troops at the Ukrainian border, but also due to the increasing delays around the approval of the new Nord Stream 2 pipeline between Russia and Germany. We can also add in threats from Belarus to block gas transit if the European Union impose further sanctions on the nation.

Markets took notice of comments from new German Chancellor Olaf Scholz who said his government will do “everything” to ensure gas supplies continue to flow through Ukraine and prevent Russia from using the Nord Stream 2 pipeline to cripple the Ukrainian economy. The Nord Stream 2 pipeline cannot be approved until it has undergone European Union scrutiny, which according to Bloomberg could take 6-8 months. The US has also has been pressuring the bloc to be ready to impose sanctions on companies/assets involved in the pipeline should Russian troops make a move across the border. European TTF gas prices and the UK equivalent surged on the headlines.

UK and European gas prices have moved in tandem with each other which is easy to explain given that according to National World 47% of the UK’s as supply comes from Europe. The price acceleration in December is exacerbated by dreadfully low gas supplies in Europe (currently 60% full) compared to the historical average, but with the Nord Stream 2 pipeline unlikely to be opened for the foreseeable, it’s hard to see how prices will normalise from an increase in supply. UK inflation is expected to reach as high as 6% when the next OFGEM price cap review comes round in April, with the cap is expected to be raised potentially as much as 40% - but the current view that reviews thereafter will lead to a reduction in the cap may increasingly be challenged as long as disputes with Russia continue. 

This poses upside risks to the inflation forecast and may prove the current market pricing correct, the question is whether raising interest rates is the right move in this environment.

Inflation Expectations

So if the BoE are focused on medium to longer term inflation expectations, where are they currently sitting? We do need to differentiate between market based measures, such as from the bond market or inflation swaps, and those from consumer/business surveys. There are merits to both, but analysts perhaps are or should be placing more weight on the latter, given that businesses are the ones with the price setting power and consumers will change their behaviour as a result. Nevertheless looking at UK market based measures over the longer term, they do remain elevated at just shy of 4% albeit not at the highs seen at the start of the month. However considering that the 10 year Breakeven (taken from the gilt market) and the 5y5y inflation swap started 2021 0.9% and 0.25% lower respectively, is this stretched enough to concern the MPC?

Looking at survey based measures, using the BoE/Kantar inflation attitudes survey in particular, the latest release for November shows the public become increasingly wary of inflation, with expectations over the next 1-2 years increasing in line with the growth in the current headline rate (they have a good correlation). Longer term expectations, over 5 years in this case, edged up to 3.1% in November from 3.0% previously – again the steadiness of the longer term figure may bring the MPC some comfort for now, hence reiterating only modest tightening in monetary policy is needed.

Cameron Willard, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg.

From all on the dealing desk, we wish you a Happy New Year, and look forward to seeing you in 2022!