A Christmas Cracker

Tightening cycle coming to its conclusion: What next?

MPC split three ways as Bank of England hikes by 50bps

The Bank of England's (BoE's) Monetary Policy Committee (MPC) voted by 6-3 to raise interest rates by 50bp in December, meaning UK interest rates now sit at 3.5%. A 50bp hike had been priced as the most likely outcome by markets. There was a small probability of the BoE going further with a 75bp hike, but data released in the run up to the decision, showing a marginal easing in the labour market and inflation coming in lower than expected, will no doubt have tilted the balance of opinion on the MPC towards a 50bp hike. 

However, there are clearly huge differences of opinion among the MPC on the right course of action. One member of the committee was in favour of a larger 75bp increase, on the basis that price and wage pressures could stay stronger for longer than projected in the BoE's November report. On the flip side, two members voted for no change to interest rates at all, arguing that the current bank rate was more than sufficient to bring inflation back to target in the medium term, given weakness in the UK economy. 

Tightening cycle is coming to a close: what next? 

Despite the split opinion amongst the MPC, it is clear that central banks across the Western world now appear to be approaching the peak of interest rates in this tightening cycle. The US Federal Reserve increased rates by 50bp in December, down from its previous four hikes each of 75bp. The ECB also pivoted to a 50bp increase in December – although, judging by Christine Lagarde’s hawkish press conference, there may be more tightening to come in the Euro Area compared to the UK or the US. This is, perhaps, unsurprising given the Euro Area’s tightening cycle started at a later stage (see Figure 1).

The two key questions for UK monetary policy now are where will interest rates peak and how long will they remain at the peak? The MPC will need to weigh up various competing priorities. The BoE confirms that the UK is probably in recession (GDP grew by 0.5% m-o-m in October, but this was only due to September’s print being artificially depressed by an additional bank holiday; the BoE is still predicting negative growth for Q4), which will act as a natural brake on inflation. The MPC will also be conscious of financial stability risks arising from the already started correction in the property market. All things considered, we are of the view that the BoE will increase rates further to a peak of 4%, below current market expectations. 

With the proviso that we do not experience a fresh geopolitical shock, it seems likely that CPI inflation's peak was in October, with the rate falling by 0.4pp y-o-y in November to 10.7%. Factors including energy price base effects, falling supply chain disruption and collapsing shipping costs will all work to reduce inflation in 2023. That said, we do not anticipate that inflation is going to be falling close to its 2% target level in the short to medium term. Services inflation, in particular, is likely to be more difficult to remove from the system due to domestically-led pressures. At this stage, we believe this will lead the BoE to hold rates at the peak of 4% throughout 2023 and into 2024. 

Quantitative tightening will further tighten financial conditions

Quantitative tightening (QT), the reduction of holdings in the Asset Purchase Programme, is also a factor to take into consideration when assessing the direction and scale of future monetary policy. Assuming the BoE proceeds with the full GBP 40bn of active sales and continues passive QT (not buying new assets to replace ones that mature) until mid-2025, the BoE will have reduced its Asset Purchase Program by roughly a quarter from its GBP 895bn peak (see Figure 2). A cautious estimate, based on evidence from the United States, suggests that this would be the equivalent of increasing interest rates by 50bp on a sustained basis. Handelsbanken UK will be publishing a paper examining the potential impact of QT early in the New Year.

In this wrap, we only need to focus on the week commencing the 12 December, in which, like a typical Christmas rush, there was a jam-packed schedule of important data and decisions for interest rate markets to digest.

Before diving into the timeline of events, a reminder of how we went into this key week of events. The October inflation report for the US, released last month, was the trigger for a significant readjustment in interest rate markets globally, with both the headline and core readings coming in below estimates at 7.7% and 6.3% respectively. Since the release we have seen bond yields move lower, exemplified by the 10 year US Treasury yield falling from over 4.2% in early November to 3.6%. The fall in 10 year Bund and Gilt yields, as well as shorter US rates has not been as dramatic, but the direction of travel has been firm. This has come with the view that inflation may have now peaked in developed markets, and with an imminent recession expected in Europe and potentially also across the Atlantic, central banks may be in position to ease off the tightening accelerator.

There is still a discrepancy between markets and the central banks. For both the Bank of England and the European Central Bank, markets are seemingly pricing in too many hikes, something that the former central bank explicitly mentioned in November. It remains more unclear in the latter, given they are behind the curve when it comes to interest rate increases. 

In the case of the Federal Reserve however, the market seems more aligned with its own forecasts. The expected peak in the Fed Funds rate initially eased from over 5% to the high 4s after the previous inflation release, but quickly retraced its moves on hawkish comments from members, including James Bullard and chairman Jay Powell himself. Even if market pricing has drifted slightly lower again, a Fed Funds rate peaking at 5% still seems about right. Despite this, there is still some debate over the timing and extent of subsequent interest rate cuts. Going into the key week in December the market was looking at between 50-75bps of cuts by the end of 2023, according to the OIS (overnight index swap) curve.

There are of course still significant divisions within the central banks too. Evidenced clearly within the MPC after the November BoE meeting with a three way split in the vote. Divisions are evident within the European Central Bank over quantitative tightening plans, whilst at the Fed, the doves are trying to outnumber chairman Powell and co into reviewing the path for interest rates.

 So, with the above scene set, let’s explore the week’s events:

Tuesday 13th: US November Inflation Report

Starting the week with a bang and probably the most important release of the week. The consensus was to again see a slowdown in the headline and core annual rate, to 7.3% and 6.1% respectively – with monthly readings of 0.3% for both. These alone would be welcomed, but would not alter the Fed’s policy yet given that even a 0.3% month-on-month rise is still not compatible with the Fed’s inflation target. A lower monthly reading of 0.2% and an annual core figure at 6% or below, would likely trigger a strong reaction with yields falling across the curve and risk assets rallying. 

So, what happened? They missed estimates again. The headline annual rate came in at 7.1% and the core bang on 6%. The monthly readings came in at 0.1% and 0.2% respectively. This allowed yields to fall between 15-20bps across the curve, with the 10 year Treasury yield trading under 3.5%. Interestingly, yields started falling prior the release, hinting at a suspicion that someone linked the report early, which the White House denies. Market expectations of the terminal rate fell into the lower end of the 4.75%-5.0% band. Rate cuts priced in across 2023 and 2024 accelerated by 20bps from the close on Monday 12th, taking the cumulative total to around 175bps+, as shown (?) in OIS and Eurodollar futures. Cuts are still heavy weighted towards 2024, but c75bp is still priced in for late 2023.

Inflation in the two components of watch, being shelter (rent and owner equivalent inflation) and used car prices, both slowed to 0.6% month-on-month (from 0.8%) and -2.9% - for the latter this is the fifth consecutive monthly fall.

Wednesday 14th: UK November inflation report and US Fed decision

UK inflation numbers followed the US in printing a lower than expected figure, with the annual headline and core rate coming in at 10.7% and 6.3% respectively, from 11.1% and 6.5% previously. Whilst the main contributors to the slowing inflation was motor fuel and tobacco prices, the MPC England will have been pleased to see a slowdown in the monthly core figure. The BoE received these numbers on the Friday prior to its official release, so will have been digested ahead of their meeting, but is unlikely to sway the majority vote in opting for a 50bp rise. As with the US, the BoE will want to see a series of prints showing disinflation before changing tune considerably. The market reaction was muted, as traders kept their hands dry ahead of the Fed meeting in the evening. 

The Fed meeting provided no real surprises, at least in our eyes. A slowdown in the pace of hikes to a half point move was nailed on prior to the meeting and as expected the supporting commentary was still rather hawkish. The Fed funds band was raised by 50bp to 4.25-4.5%. The members’ forecasts, illustrated by the dot plots saw the peak in the Fed Funds rate lifted to 5.1% in 2023, with 17 out of the 19 members seeing it above 5%. This marries with the comments from Powell and co in the last meeting, that they see the peak in rates higher than previously expected. The forecasts also showed a lift in the central projection for 2024 to 4.1%, whilst the economic projections imply that core inflation will remain rather sticky at 3.5% in 2023 from 3.1% previously and that the economy will manage a soft landing. All in all, the message has not changed from before, Powell reiterated that there is still more to be done and that rate cuts will not be considered until the Fed are “really confident that inflation is coming down in a sustained way”.

The market however was not buying it, as we only saw modest adjustments after the decision and press conference. The pricing for the peak remains in the 4.75-5% range, now underneath what is projected by the central bank themselves (albeit marginally), and the pricing for rate cuts barely budged. Longer term Treasury yields also hardly moved by close after an initial surge. This is likely due to two reasons, one being simply that the market heard what it wants to hear, such as Powell’s acknowledgement of cooling inflation and forecasts for higher unemployment and that policy is well advanced in its cycle, or that the market is confident that we will see a sustained cooling in inflation and a softening labour market in the coming months – indicating perhaps a harder landing than what is expected. Markets are weighing towards a smaller 25bp hike on 1 February , although are still pricing in a degree of upside risk for another 50bp move.

Thursday 15th: ECB and BoE decision

Starting the week’s finale we had the BoE decision where as expected Bank Rate was raised to 3.5% from 3.0%. On first glance the decision looked rather dovish, given that only one member Catherine Mann, voted for a larger 75bp rise this time and only Tenreyro and Dhingra voted for no change at all, given their view that the current level is sufficient to tackle inflation. The rest voted for a half point rise. The BoE will also starting selling longer dated bonds from its portfolio in Q1 next year.

Looking into the supporting commentary however and there is a slightly more hawkish tilt, noting that the labour market remains tight and that “there is evidence that inflationary pressures in prices and wages that could indicate greater persistence”, justifying a more forceful response. What’s even more noteworthy was the removal of the line in November’s commentary that suggested that market pricing was too aggressive. However, we should caveat this by saying market pricing is way off levels seen in early November when the committee last met. 

The market focused more on the dovish headlines with rates falling across the curve and the terminal rate has now fallen below 4.5%. This is expected considering there was a residual risk of a larger move in the market’s eyes with 54bps priced in for the meeting. Looking longer term, swaps were trending lower on the day prior to the midday decision, losing 10 bps in the 5 to 10 year segment. However, following the ECB (see below), this quickly reversed.

Focus now turns to the next meeting on 2 February , in which the market is torn between another 50bp rise or a smaller quarter point rise. At this stage, and given my view that there is a strong chance the Fed will opt for a smaller 25bp move in the next meeting, I expect the BoE to opt for two 25bp moves in Feb and March, rather than a straight 50bp in Feb. At 4%, and in line with our economist’s views, there is a good chance that this will be the last one.

Last but by no means least, the European Central Bank decision came in the afternoon where the Deposit Facility rate was also increased by, you guessed it, 50bps! This leaves the rate to end 2022 at 2%. The commentary however surprised to the hawkish side, with inflation forecasts ramped up for 2024 – therefore concluding that interest rates will still have to rise significantly at a steady pace. We also got concrete plans on quantitative tightening, with reinvestments in the Asset Purchase Programme (APP) declining to EUR15bn on average from March through to the end of the second quarter, after which its pace “will be determined over time”. Market interest rates rose after the decision and during Lagarde’s briefing. The market now sees the terminal rate for the Deposit Facility above 3%, the 10 year German bund yield extended above 2%, whilst the spread to its Italian equivalent also widened to 215bps from lows of 180bps last month.

To wrap up…

Well, what a year! Not one we have experienced ever, but it might be safe to say we are through the most if it, at least for interest rate hikes. We may dive deeper into our views for next year in January’s wrap, but to summarise we would say that whilst hikes are nearing an end in the US and UK, we don’t expect subsequent cuts to be on the agenda for next year, just yet. For Europe, given that they are behind the curve, they have further to go before they reach the peak.

Have a great Christmas and a Happy New Year!

Cameron Willard, Capital Markets

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