Who said the summer would be quiet?

On Tuesday, July 19, Bank of England (BoE) Governor Andrew Bailey addressed guests at London’s Mansion House with a speech entitled, “Bringing inflation back to the 2% target, no ifs no buts”. The message was clear: he stressed that the BoE now sees “the balance of risks to inflation as on the upside,” and that any signs of greater persistence of inflation would lead the Bank to act forcefully. Crucially, he explicitly stated that a 50bps increase in interest rates will be among the options for the Monetary Policy Committee (MPC) at its next meeting in August. 

Handelsbanken UK Economics were initially expecting a further two 25bps hikes from the BoE this year. However, we have revised our forecast upwards. Many other central banks are increasing the size of interest rate hikes. For example, at their last meetings the Federal Reserve, and Bank of Canada raised rates by 75bps and 100bps respectively. Moreover, the European Central Bank (ECB) unexpectedly hiked rates by 50bps at its latest meeting. The BoE will be very conscious of the impact this will have on Sterling’s exchange rate, especially at a time when the trade deficit is so high. June’s CPI inflation print of 9.4% – up 0.3pp from May and slightly higher than market expectations – will also no doubt weigh on the minds of MPC members. We therefore now believe that the BoE will increase interest rates by 50bps up to 1.75% in August. This would be a very significant move by the MPC: the BoE has never increased rates by 50bps since it became independent in 1997. We still expect a further 25bps rise later in the year, which would leave bank rate at 2% year end.

Market expectations continue to price in additional aggressive hikes in BoE interest rates over the course of this year, predicting that bank rate will settle at around 3% by the start of 2023. We continue to feel that market expectations are too high. Governor Andrew Bailey has now confirmed that between £50–100bn of quantitative tightening will be pursued over the first year, which will require active sales of gilts in the BoE’s Asset Purchase Programme. This will act as a deflationary force and there are also some optimistic signs that other factors will bear down on inflationary pressures over the short to medium term: the global supply chain index is down 45% between December 2021 and June 2022; shipping rates have fallen around 30% since the start of this year, according to the Drewry World Container index; commodity prices have seen a dip in recent weeks; and inactivity levels are showing a welcome downward trend, which will help to alleviate labour market pressures. And despite an unexpected 50bps rate hike in July, the ECB’s constrained ability to raise interest rates due to concerns around peripheral Euro economy debt markets will also ease pressure on the BoE to increase rates aggressively following the August meeting.

Recession reality to bring rates down to earth?

It has been without doubt a whirlwind of a month, from rates reaching new highs in mid-June following the semi-surprise hike from the Federal Reserve and the hawkish tones from the ECB and Bank of England, to an environment where momentum seemed to be shifting towards lower rates. Expectations for cycle peaks in policy rates had been lowered before rebounding, but timeframes for rate cuts have been brought forward, also allowing for longer term rates to drop as well.

Recession fears have become the dominant driver of the market in recent weeks, impacting all assets from currencies to equites and commodities. Brent crude oil fell briefly back below $100 a barrel, the euro breached parity and the pound has lost further ground against the dollar (see more below). Equities are trading between two competing forces, the recession threat against falling market interest rates – which the latter benefits “growth” stocks in particular, as future earnings improve when they are being discounted at lower rates. In the sovereign bond space, the 10 -year US Treasury sits marginally below 3%, off highs near 3.5%, whilst the German Bund equivalent continues its march back below 1%.

We may have had a strong argument that markets have finally had that lightbulb moment, allowing a degree of realism into trade. However given volatility remains elevated, that suggests that there is still a lack of clear conviction in this. This is particularly evident in the US where we have a real mix of data:, on the one side consumer confidence and the housing market data are looking weak and inflation expectations lowering, on the other side headline employment data still remains decent (Non-farm payrolls for June printed at 372,000, well above the 265,000 expected). US inflation added further complication where the headline figure surpassed expectations reaching 9.1% annually, and on a monthly basis rising the most since 2005.

The Federal Reserve has held firm in its fight to tackle inflation, and many members of the central bank remain confident a recession can be avoided, even if chairman Jay Powell sounded less convinced in his testimony to Congress at the end of last month. The employment and inflation data has more or less guaranteed that we will see at least 75bp hike later this month (analysis of the meeting will be in the August wrap). However, following the jumbo hike of 100bp in Canada, markets have been emboldened to price in as much as a 60% chance of a hike of similar magnitude from the Fed at one stage, before the University of Michigan data showed long term inflation expectations fell to 2.8%. 75bp currently remains the base case.

The chart below shows just how much rate hikes expectations have changed from the week of June’s Fed and BoE meetings. Even though short- term rate expectations increased after the inflation print globally, the curve inverted even more with longer term rates barely budging. Indeed rate cuts are now expected in the US and UK as early as the spring of next year. Cuts are not anticipated in Europe purely due to the fact they have only just started this month, prompting a phrase I like that they are, “So far behind the curve that they are now actually perhaps ahead of the curve” – seems rather fitting for the ECB!

UK to hike by 50bp?

Risks of a recession are more elevated in the UK, with the increased cost of living starting to eat into incomes, and with consumer confidence at records lows it seems unlikely many will want to dip into their savings to keep up with their spending habits. The Bank of England is well aware of this and hence has indicated via forecasts that it does not agree with market expectations for rate increases, but remains vigilant to inflation developments. With this in mind, it may also be viewed that the window of opportunity to raise interest rates is narrowing, and with central banks opting for big moves, 75 in the US, 100 in Canada and even 50 from the European Central Bank, the BoE may also need to consider front-loading hikes. Indeed, the market is pricing in a 50bp hike in August and a strong chance of two subsequent hikes of a similar magnitude in September and November.

More focus on Sterling?

With bumper hikes being seen globally, one concern for MPC members, which BoE committee member Catherine Mann has alluded to in two separate speeches, is the current weakening of the pound and subsequent impact on inflation via imports. Sterling has had a torrid time in recent months versus the dollar for a variety of reasons 1) Interest rate differentials favouring the dollar, 2) Risk sentiment in the market souring and 3) A growing current account deficit and 4) Political woes. 

More weight must be placed on the former three points, as politics has not had a major role in Sterling’s movements yet, in fact the resignation of Boris Johnson actually benefited the pound, albeit marginally, on the view his replacement could opt for friendlier ties with Europe, provide more fiscal support and have better chances come the next general election. We now know it will be either Rishi Sunak or Liz Truss, and neither candidate are likely to rock the boat considerably although Truss is keen to reverse tax increases that Sunak isn’t. Either way, politics is likely to continue to play only a marginal role in the pound’s fortunes.

In any case, it’s not a good time to be a Sterling bull right now, with GBP/USD falling below 1.20 and eyeing pandemic lows just shy of 1.15. Weakness against the euro has been minimal, and only shifted in the euro’s favour once the ECB turned hawkish, as interest rate differentials remain the main driver in this pair.

Ms Mann, one of the members who backed a 50bp hike in both May and June, called for the BoE to have “heightened awareness” of the pound’s role in inflation. She is not wrong, with imports equating to 28% of GDP (Pantheon) and the inflationary impacts of a weaker pound filtering through over a lagged timeframe. Previous estimates from the MPC suggest that a 10% fall in the effective exchange rate lifts consumer-price inflation by 2.75%, with the peak impact evident after two to three years.

With the above, the spike higher in gas prices throughout June, and an increase in price and wage expectations as recorded by the latest Bank of England Decision Maker Panel (DMP) survey, where firms reported that they expect to increase their selling prices over the next year by 6.3% (up from 5.9%) and expect wages to rise by 5.1% (up from 4.8%), all add ammunition to Ms Mann’s call for the ‘front-loading’ of hikes. 

There is no reason for Ms Mann to change tune in August, and Michael Saunders will continue his push for a 50bp hike to go out with a bang, as he leaves the committee in the days after. In what will be a lively meeting, I look at Governor Bailey and Dave Ramsden as the most likely candidates to switch sides, but I can’t rule out more either. As a side note, Mr Saunders’ successor, Dr Swati Dhingra, from her initial remarks will likely lean on the dovish side, casting further doubt as to how far interest rates will climb as we head into the autumn.

ECB hike, announce fragmentation tool

Despite forward guidance confirming a 25bp hike in July was coming, the ECB went further and raised rates by 50bp, taking the Deposit Facility Rate to 0%. The market had priced in a probability of a bigger hike just shy of 50%. The board clearly took a leaf out of the Fed’s book, with reports circling in the prior days that a 50bp hike was on the cards. Like what may be the base case with the Bank of England on August 4th, it seems the hawks are getting worried about the timeframe of opportunity to raise rates and did not want to wait until September for a bigger hike at a time when a recession may be around the corner. As the move was not fully priced in, rates did move higher post-decision but quickly reversed course. Yields on 10-year bonds of core/semi-core countries (Germany, Netherlands, France) were up only around 2-4 basis points. With the ECB also moving away from forward guidance in future, this makes September’s decision wide open, installing more volatility into European rates.

The ECB also announced its new tool to “counter unwarranted, disorderly market dynamics”, which is being called the Transmission Protection Instrument (TPI). The details were initially very vague, intentionally so, but in Christine Lagarde’s press conference she said the governing council has specified certain criteria for its use, which is within its own discretion. This conditionality is there to avoid any potential run-in with courts that we have seen in the past. Its use is not also restricted ex ante. This has not provided the needed support for Italian bonds yet, which are suffering on increased political premium following the resignation of Mario Draghi and the snap election to be held in September, where initial polls point to a right-wing populist government led by Fratelli d’Italia leader Giorgia Meloni being the likely winner. The 10-year Italian BTP-German Bund spread stands at just over 230bps, close to the 240-250 levels seen in June which prompted the ECB to hold an emergency meeting.

Cameron Willard, Capital Markets

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