From manic May to jumpy June

Monetary Policy Committee raised rates in line with expectations

The Bank of England’s Monetary Policy Committee (MPC) raised rates by 25bp to 1.25% on June 16, in line with economists' expectations but below what many market participants had been expecting. The vote was split 6-3, with Governor Andrew Bailey voting for a 25bp hike. 

Looking forward, at Handelsbanken we have raised our forecast for the ultimate rate from 1.5% to 1.75%, and that at the peak the BoE will end its hiking cycle. Our forecast remains in the lower half of economists’ expectations, which range from between 0.75 and 3%. Economists’ expectations have been generally below market consensus of 2% or more, markets being focused on inflation continuing well above target, while economists focusing on that, plus the steadily worsening GDP outlook. The MPC appears to continue to believe that inflation pressures are to a significance degree transitory and it’s happy to see sterling taking much of the interim pain.

UK likely to avoid recession, but only just

The Bank of England will as always be looking to implement what it sees as the optimum monetary policy for the UK, while being cognisant of the actions of other key central banks. The 75bp US Federal Reserve move on 15 June, and the implications from US Fed Governor Powell that more is on the way, have clearly set the pace. Meanwhile, the European Central Bank in its emergency meeting on June 15 was looking for ways to tighten monetary policy, both to increase rates as well as to begin a programme of Quantitative Tightening. It also has to provide necessary support to prevent undue “fragmentation”, that is undue market pressure on weaker economies which often are carrying high debt burdens. For the moment the ECB has said it plans to raise interest rates in July by 25bps, and again in September, by an amount determined by the medium-term inflation outlook. The need for new tools to carry out any “anti-fragmentation” policy does suggest that the pace of rate rises from the ECB will lag those of the Fed.

Looking to that UK economic forecast, we have been predicting a decline in UK GDP of 0.6% this quarter, and we were forecasting growth of 0.1% in Q3 and again in Q4, so a recession was technically avoided. The modest 25bp tightening means a recession is avoidable, but only just. Much depends on consumer confidence. To support consumer spending levels the Chancellor has announced a package of measures worth £15bn aimed at ameliorating the higher cost of energy, the question is whether this is enough? Our forecast depends on consumers being willing to lower their savings rate from just under 7% to less than 3%, with the money not saved being used to meet the higher cost of living. There is every reason to see this as a reasonable path, but the fact that consumer confidence is the lowest it’s been since 1974 does suggest that the negativity is more emotional than rational and thus harder to predict. 

Implications for Quantitative Tightening

We believe that the MPC is looking for Quantitative Tightening (QT) to do much of the necessary monetary policy tightening. The Asset Purchase facility has already fallen from £895bn to £866bn, with a further fall of £3.2bn in July, and there is the possibility of an active selling programme coming after the QT report expected in August. One must remember that the QT path we are on remains an uncertain one and central banks are naturally cautious about how rapidly they run down their stock of assets and the broader impact on asset prices generally. On the present path of passive non-reinvestment of funds, 20% of the stock of assets at the bank will be run off by 2025 and 50% by 2030. 

James Sproule, Chief Economist

Fed delivers first 75bp hike since 1994

May’s US inflation report sent the market into panic mode in the days before the Federal Reserve meeting, the surprise 1% month-on-month acceleration, lifting the annual headline rate to 8.6% caught the market off guard, sending yields across the globe into a frenzy. Two-year US yields rose to as high as 3.4%, whilst the 10-year equivalent rose to just shy of 3.5%. The 2s10s curve also briefly inverted again, raising concerns about a forthcoming recession in the US once more. Normally, when you see outsized moves one way or another, you would find some form of reversion taking place soon after, but that didn’t come as the Fed meeting approached. Instead, yields were pushed higher following the release of an article in the Wall Street Journal which indicated that the Fed was likely to consider a 75bp hike in June’s meeting, rather than the 50bp hike that has already been committed to. It didn’t take long before the market endorsed this view, with the short-term swap market attaching a 100% probability of a hike of that magnitude. 

Despite it being unclear whether this was merely the journalist’s opinion, or some form of official hint from the Fed, the arguments for a bigger move are clear. The Fed does not want to be seen as being behind the curve on inflation, and the data for May will have not helped, therefore the question is why wait? The difference between a 50bp hike and a 75bp hike in the short term is trivial, especially when rates are expected to rise significantly more anyway – therefore it’s a rather easy win to showcase that it’s trying to do more. What’s more important is the guidance going forward; where will the terminal rate now lie? And in what timeframe and increments will it get there?

The Fed followed through with a 75bp hike, taking the upper bound of the Fed Funds rate to 1.75%. This was accompanied by an update to forecasts, including to the dot plots which show the median projection for interest rates going forward. The median rate for 2022 was increased to 3.4%, and its noteworthy that every member forecasts rates to reach at least 3%, whilst the 2023 median increased to 3.8%. The longer-term forecasts edged up to 2.5% from 2.4% previously.

Chairman Powell confirmed that a 50bp or 75bp is “most likely” at the next meeting in July, but reiterated that he does not expect moves of this size to be “common”. The latter statement helped market rates cool post decision, with a bit of “buy the rumour, sell the fact” playing a part too. In typical fashion recently though, rates found a way to rebound after the following days surprise 50bp hike from the Swiss National Bank and the Bank of England meeting (see below). Lastly, whilst acknowledging that rates will be raised into restrictive territory, Mr Powell dismissed the suggestion that the Fed was trying to induce a recession. In spite of his remarks, talks of a recession continue to heat up, which did actually help market rates eventually start to take a breather as the end of the hectic week approached, but two and 10-year Treasury yields remain comfortable above 3%.

Aside from the well-known central bank conundrum of tackling inflation versus igniting a slowdown in growth, the implications of the Fed’s activity this month pose further questions. As the Fed moved away from its pre-committed 50bp hike in June, what implications does this have for the use of forward guidance in the future? Does the market now take the guidance for July with a pinch of salt, perhaps it’s Ignored completely? (which is true for the Bank of England already). This can potentially open a dangerous can of worms, given that this is something the Fed has been the poster child of over the past two years. But the fact that the Fed now seems more aligned with the market view will provide some comfort.

However this could potentially ensure that elevated volatility becomes the norm over the course of this year and next, reducing liquidity and tightening financial conditions further. To some degree this is a good thing for central banks, as the market does some of the work for them, but there comes a time where negative externalities outweigh the desired effect. We have already seen this in Europe, after the June 9 hawkish European Central Bank meeting in which a hike in July was confirmed, and the door is open for a larger 50bp move in September. Peripheral spreads, especially in Italy started to blow out (10-year German Bund/Italian BTP spread reached nearly 250bps at one stage, with the latter’s yield hitting 4%) as the market was left disappointed by the lack of details of a new facility designed to tackle any market fragmentation. The fallout prompted an “ad hoc”, another word for emergency, let’s be clear, ECB meeting to tackle market conditions.

The concerns that may arise at the Fed will be different, in particular the conditions of the repo market (a key pipe in the plumbing of the financial system) which are far from optimal – a space that we continue to watch closely.

BoE hike, but not as exciting…

The Monetary Policy Committee stood firm in its June meeting, sticking with another 25bp hike taking Bank Rate to 1.25%. A balancing act between growth and inflation, and the fact that some may argue it is ahead of the curve when it comes to raising rates support the argument for a conservative hike.

Whilst this met the consensus view, the market was more or less split 50-50 on whether we would see a hike of a bigger magnitude. The split amongst the MPC remained the same as May’s meeting, with six voting in favour of a quarter point move whilst three dissenters, Haskel, Saunders and Mann again voted for a larger 50bp increase. I placed a remote possibility that we may see a three-way split, with Cuniliffe and/or Tenreyro voting to keep rates on hold, however this outcome now sees unlikely for the foreseeable.

In more or less replica fashion to the May meeting, rates took a knee-jerk dip lower before rebounding and surpassing pre-meeting levels. This came seemingly after a re-read of the statement where the market ignored the removal of the sentence that the committee sees “some degree” of further tightening as necessary (a dovish hint?) and instead focused on the fact that the committee was unanimous in endorsing more forceful moves if inflation becomes more persistent, something that Huw Pill echoed on the wires the following day, noting that more aggressive action would be needed if evidence of a wage price spiral were to emerge. This to me seems to be the MPC’s acknowledgement of the Fed’s larger move, reiterating to the market that it will accelerate the tightening if conditions require, although they do not see it as necessary yet. 

From the bank’s comms point of view though market reaction was far from desirable; Swap rates and bond yields were up across the curve by c15-20bps, with some minor curve flattening. Two-year market swap rates breached 3% with fives not far behind, 10-year swaps sit around 20bps lower than five year rates. However, with talk of a recession ramping up in the US, we did some cooling, back to pre-meeting levels.

The recession risk however is not impacting rates at the very short-end, given that further rate increases are to come. Looking at the OIS market, traders see Bank Rate above 3%, with a 50bp hike fully priced in for the August meeting plus a strong chance of two further hikes of 50bp in the September and November meeting.

This makes the August meeting even more juicy, I doubt the MPC will live up to expectations of a potential 75bp rise, meaning volatility is likely to be a given. Add in the expected announcement of the bank’s plan for outright asset sales too and we get even more event risk. We are still waiting for that light bulb moment where markets may reconsider their bets on rate rises, it will likely need to be something explicit from the BoE, a surprise hold or a clear dovish change in communication – but Andrew Bailey and co are not there yet, sensibly awaiting further developments.

What about rate cuts?

It may seem very premature to be talking about rate cuts, but given that rate hikes are continuously being brought forward, subsequently rate cuts have also been brought forward too. Rates, particularly in the US are expected to be taken into “restrictive” territory, therefore over time there would be a need to reduce rates to bring them more towards the observed neutral rate. The time between the end of a tightening cycle and the start of an easing cycle throughout history is actually quite short, around seven months.

Just as the market and economists disagree on the path for rate hikes, they also are diverging on the time of rate cuts. In the US, markets expect 0.75% worth of cuts in the next two years, starting in the summer of 2023. Economists however expect the first cut not to come until the end of 2024. This divergence does make sense, the market clearly feels that either further tightening (relative to forecasters) is needed to keep inflation expectations anchored by purposely slowing growth, or feels there is the potential for a policy mistake, hence a quicker unwind. All in all, as the debate about rate hikes has and will continue to dominate the narrative for the foreseeable, we may be in for a carbon copy, but in reverse, in next 18 months to two years.

As for the UK, the timeframe as indicated by the market is fairly similar, looking for a rate cut towards the end of 2023 from a peak of potentially 3.50%.

Cameron Willard, Capital Markets

All data, unless otherwise stated, is sourced from Bloomberg