New year, same stories?

Inflation overshoots expectations again

Prices continue to climb for British consumers with the headline inflation rate (CPI) hitting 5.4% for December 2021 – its highest level since March 1992. This came in above market expectations and well in excess of what the Bank of England (BoE) was projecting just a few months ago. For example, the August Monetary Policy report forecast a peak of around 4% this Spring. The measure of inflation which includes housing costs (CPIH), has also increased, now standing at 4.8% for December 2021 (year on year) compared to 4.6% for November 2021. 

Meantime, energy prices continue to be a major driver of inflation – 12-month inflation rates in October 2021 were a whopping 18.8% for electricity and 28.1% for gas – but latest figures show other factors are also at play. Indeed, food inflation has shot up (4.2% from 2.5%), core goods inflation is on the rise (5.2% from 4.8%) and services inflation increased to 3.4%, which is its highest rate since June 2013. Inflation is proving to be much more stubborn than the BoE initially anticipated, and although there remains a consensus that recent price spikes are “transitory”, the increasingly broad drivers of inflation suggest that a rapid reversal to the target rate of 2% will be difficult, something which will no doubt be playing on the minds of policymakers.

Moderate tightening will continue

There is thankfully no evidence yet of a wage-price spiral (latest earnings data shows the rate of pay growth has fallen quite significantly), but the severity of current inflation will mean the BoE needs to act to reduce the likelihood of such a scenario. Monetary policy over the course of 2022 is likely therefore to continue tightening, albeit moderately. We are expecting earlier interest rate rises this year – one in February and one in August – that would take the base rate up to 0.75%. The quantitative easing (QE) programme reached its £895bn target level of purchases, at the end of last year, and we do not believe there is the prospect of further asset purchases. Indeed, the BoE’s current guidance suggests that it should begin to unwind QE, that is reduce its stock of asset purchases, by not reinvesting maturing assets once the Bank Rate hits 0.5%, which we expect to happen in February. This is not, of course, unconditional guidance – it will only happen “if appropriate given the economic circumstances”. Given the economic hit arising from the Omicron Covid variant, it seems likely that the BoE will proceed cautiously with any quantitative tightening in the near future.

The upcoming squeeze

GDP figures for November 2021 brought welcome news that the UK economy had passed its pre-pandemic level, and the government’s recent announcement that it will remove Plan B restrictions later in January bodes well for the economy overall. However, that is not to say that the coming months will be plain sailing. The latest GDP figures do not factor in the impact of Omicron and there is also an upcoming squeeze on living standards that will act as a brake on economic growth. Without any changes to government policy, consumers will be hit by a double whammy in April 2022: tax rises – including the increase in national insurance – will impact aggregate incomes by as much as £15bn per year, and the re-rating of the energy price cap for residential consumers could lift energy prices by around 40%. Markets are waiting to see whether the government makes any announcements in the coming weeks that might dampen some of these rises to the cost of living.   

Daniel Mahoney, UK Economist

All about the US

As the new trading year kicks off, the drivers of the rates market will again centre on similar headlines, namely the pandemic, inflation and central bank action. On the former, the threats of the Omicron variant have seemingly subsided given that the variant has peaked or is peaking in developed nations. That is not to say it won’t have a short-term impact on economic growth, but from the markets’ forward-looking view, this is perhaps already considered over.

As for the latter two, inflation and central bank action will remain for the time-being the focus of all interested minds. The UK market is probably still feeling the effects of the surprise December rate hike, and the communication mishaps of the Monetary Policy Committee (MPC), which makes for a rather uncertain, anxious feeling among traders ahead of upcoming meetings. Much more comfort has come from their peers across the pond at the Federal Reserve, where communication has been met with the expected action.

Moves in interest rates throughout 2022 have so far been solely tied to the movement in US yields, which rose dramatically in the first two weeks of the year before easing somewhat. This came as the market ramped up expectations for interest rate increases this year. The Fed has moved its stance relatively quickly if we think back to the forecasts of last summer, but has acted in a way that, so far, has avoided upsetting the market in a similar fashion to 2013 when rates rose rapidly after the Fed changed tune, the so-called “Taper Tantrum”. So far so good, but the wild swings seen in the equity market this month may signal more unease going forward.

All expect, considering the pace of the US recovery, that interest rates will have to rise this year, but what is less certain is what the voting members will do with the balance sheet, and this is injecting volatility into the rates market, creating rather choppy waters. The Fed has tapered its monthly purchases by $30bn so far, and purchases will end in March, the question is how will it reduce its balance sheet, or quantitative tightening (QT) as it’s known? In the December minutes of the Fed meeting "some participants... noted that it could be appropriate to begin to reduce the size of the Federal Reserve's balance sheet relatively soon after beginning to raise the federal funds rate”. 

The January 26 meeting and subsequent comments from Powell confirmed the market’s view that a hike is imminent, with lift-off pretty much guaranteed in March. There was relatively little to go on regarding the balance sheet. Purchases will end in March as already indicated, but no timescales were provided for reduction, even in a separate press release titled, “The principles for reducing the size of the balance sheet”. The only interesting detail in there was that the Fed plans for the bulk of the balance sheet to be made up of government Treasuries, suggesting the mortgage backed securities (MBS) held will fall away at a greater pace.

Everything else at this point however is speculation, but judging by analysts’ predictions we may be waiting until Q3 for QT to commence.

It does seem that the Fed may opt to take a slow road on QT and use interest rates as the main tightening tool. Some members would have probably liked something more aggressive on QT, but it is very unlikely. Playing devil’s advocate though, whilst the Fed wants to avoid market turmoil, I don’t think it is very comfortable with yields being this low with tightening imminent, so something more aggressive may be deemed necessary further down the line if we do see the Treasury curve invert, where yields in the 2-5 year area exceed those on 10 year notes and beyond.

But with rate hikes being the primary tool, the question is how much we will see. Powell effectively led on that every meeting this year is a “live” by failing to rule out a hike at every meeting. The market now sees five hikes in 2022 (see chart below) and some analysts are calling for up to 7! Despite the growing signals that we could see a 50bp hike in March, I’m sticking to just a 0.25% rise.

Another UK hike on February 3?

As expected, the US moves have filtered through into UK rates, whether it be bond yields or swap rates, which are both climbing in tandem. The fact that the threats posed by Omicron have dwindled as case numbers peaked, and all restrictions have been removed, means markets have been able to firm up calls on further interest rate increases this year – with some help from the Fed too. The familiar chart below sets the scene for the year, with the future implied bank rate sitting at close to 1.5% by year-end – meaning nearly five hikes are priced in.

Political noise around Westminster is not expected to impact markets greatly, even if Prime Minister Boris Johnson does step down. A potential replacement, whether that is Rishi Sunak or Liz Truss, the current favourites, is not going to rock the boat in reference to fiscal policies, although some reports suggest the Chancellor is concerned about current spending. This therefore narrows the focus back to the data and communique from the MPC. Data-wise, the labour market continues to impress, with the unemployment rate approaching its record low, and the more timely claimant count rate also declining. On the wage growth side, the three-month/year-on-year rate is holding above 4%, but taking into account inflation, the ‘real’ figure in November fell for the first time since July 2020. The concern for the MPC is that employees may start to feel the squeeze of purchasing power and in turn look to negotiate higher wages to compensate.

With January’s data on UK economic health, the market is more or less in no doubt that we will see another 0.25% hike on February 3, with implied probability of a hike sitting at 90+%. This will be the first time since 2004 that we have seen two hikes in consecutive meetings.

Communication from the BoE pre-blackout has been relatively sparse, which is probably a good thing. We’ve only heard from Governor Bailey and new MPC member Catherine Mann. Ms Mann notes monetary policy needs to “lean” against “strong inflation”, but her tone suggests she favours a more cautious approach. Mr Bailey’s comments added nothing new; he is still concerned over gas prices, and he notes agents are seeing evidence of “second round inflation”.

Swap rates have shifted quite significantly this month so far given all of the above, and ahead of the February 3 meeting the bar is high to see any further acceleration if rates are raised. The BoE has already said that the balance sheet will start to be reduced once the bank rate reaches 0.5%, so any further commentary in the report will be watched closely. We may see a typical knee-jerk reaction to the downside if the BoE surprises by keeping rates on hold, or softens its tone (A “dovish hike”), akin to what we saw in the aftermath of the November meeting.

However, at least in H1 2022 the UK curve dynamics are unlikely to change course as further rate increases come, whether it be February or May, but by the summer we should know whether the market prediction of at least four hikes this year is on course to happen, or will there need to be a shift in positioning? This may not play out until the autumn though, after the usual summer lull in activity.

Cameron Willard, Capital Markets

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