BoE hit with surprise, are we now looking at a Christmas hike?

Future promises, with an emphasis on future

In early November interest rate observers found to their chagrin that they had been over interpreting the pronouncements of the Bank of England Governor Andrew Bailey, and that while interest rate rises remain firmly on the agenda, that are not coming quite a quickly as anticipated. (Should the Governor have done more to correct market misconceptions as they became apparent? Answers on a post card please.) It was in retrospect always a bit of a steep hill to climb to move from the Sept Monetary Policy Committee meeting, when the vote was 9-0 to keep rates at 0.1%, to a majority in favour of tightening. Encouragingly for those of us who think rates should rise, the Committee split its vote by 7-2 in Nov in favour of keeping rates on hold at 0.1%, opening a path forward to tightening. However, despite the (anticipated) surge in Octobers inflationary figures, we note that the next meeting in December will only report the results of the vote, there will not be any more detailed explanation of MPC’s thinking. Thus, our expectation is that a change is most likely in Feb 2022 alongside the next Monetary Policy Report, at which point rates will rise to 0.25%. We expect a further rise to 0.5% in Q4 of 2022, but not much after that as by then consumer demand is likely to have faded. 

Parts of inflation may be transitory, but there is more to come before any fading can be expected

While the Bank of England forecasters maintain that they expect inflation to reach 5% in the first half of 2022, they also maintain that it will fade reasonably quickly thereafter, with inflation expected to be down to its target level of 2% in 2023. The latest data puts inflation at 3.8%, and it looks set to rise further over the autumn and winter as the impact of higher energy prices and tax rises are passed through to consumers; our year-end inflation forecast is for 4.2%. We have for some time argued that much of the inflation story is transitory, and we would continue to argue that the base effect, as well as frictional effects in the labour market opening up post COVID, will pass over the course of 2022. But there have equally always been longer-term inflationary concerns, from a continuation of the above productivity justified wage rises seen in recent months, through to the ultimate impact of significant expansion of the monetary base.

Quantitative Easing: completed

The Bank of England’s Asset Purchase Scheme, known as Quantitative Easing, is now drawing to a close. The November MPC meeting voted by 6-3 to not end the program slightly early, at least some MPC members wishing to signal they would like to see some monetary tightening. Looking forward that signalling disappears as an option as the QE program it is set to reach its goal of GBP 875bn Gilts, GBP 20bn in corporate bonds by the end of Dec. The intention for 2022 remains to cease reinvesting QE proceeds once interest rates hit 0.5% and in the interim the MPC is left to signal its inflationary concerns with either raising rates, giving lots of speeches that they understand the inflationary challenge, or finding some new ways of reinforcing their credibility. 

James Sproule, Chief Economist

Well, the November 4th meeting didn’t quite go according to plan for the market, who were more or less adamant we would see a 15bps rate hike taking Bank Rate to 0.25%, as the Monetary Policy Committee voted 7-2 in favour of keeping rates on hold. The split in the decision was perhaps just as surprising considering many, including myself, thought it would be a lot closer with perhaps only one vote in it (5-4 split) either way – although despite the seemingly convincing outcome some of the MPC members conceded that the decision was a close one, something we can only take their word for.

The reasoning for remaining on hold was clear in the briefings, and something that was talked about in the previous Rate Wrap, namely awaiting data. The MPC want to wait for more clarity on the state of the labour market after the end of the furlough scheme, which they will have the official data for October to hand in time for the December meeting, this will provide the desired insights into the level of slack in the labour market and therefore what impact this will have on the supply of labour and wage growth. September’s data (unemployment rate falling to 4.3%) and early  indicators for October were also strong, and inflation is running above forecast, so perhaps the mind of some members has been made up already.

I had called for a hike in November on the basis that given the emphasis on communication and forward guidance in the modern central banking textbook, it made sense to use the platforms of a Monetary Policy Report and a press conference to explain their decision to hike and what may come next. Whether the decision was right or wrong, and I think there is a sensible justification as to why it was the right call, the problem is the communication of this which quite frankly was rather poor. MPC members, and in particular Andrew Bailey had plenty of opportunities to push back against the market consensus of a hike but he decided not to, and in fact, whether intentionally or not, he probably added fuel to the fire on occasions with comments such as “we will have to act” – although financial media play a role here in taking comments out of context.

Nevertheless one would think that the BoE would learn from past. Previous Governor Mark Carney was labelled the “unreliable boyfriend” back in 2014 for sending mixed signals to the market on the timing of an interest rate hike (sound familiar?) in which he and the BoE mentioned the possibility of raising rates sooner, only to later change course and play down such a move. Perhaps he is due some slack, data changes and forecasts change as a result which can’t be helped – take the pandemic as a case in point – but communicating this to the market swiftly and clearly is where Carney and co struggled. This perhaps is playing out again with a new unreliable boyfriend, albeit early days, but still not the best of starts.

So what next?

It is clear that despite the decision the future path for interest rates has not changed, the can has just been kicked down the road. Both economists and the market still expect interest rate increases ahead, but the question now is whether that comes just in time for Christmas or in February next year. On balance, it seems a December hike is highly favoured at this point. The labour market data for September was strong as mentioned, and the official October data is unlikely to throw up any unwanted surprises, like a significant increase in underemployment, considering the record level of job vacancies available. This, as well as inflation running 0.3% above forecasts could provide enough ammunition to swing MPC members like Bailey, Pill and either/or Broadbent and Cuniliffe. If you couple this with the view held by some that the MPC will want to appease the market following the fallout this month then this provides a strong case for a 15bps hike on December 16th.

However, whilst I probably lean to a December hike, I still think there is some merit in waiting until February. My reasoning is not too dissimilar in that again, the decision is accompanied by new forecasts and a press conference, and it provides the MPC more time to assess the winter struggles, whether it be virus cases or the squeeze of higher energy prices, and what impact this has on consumer confidence. I must quickly refer as well to the previous rate wrap and reiterate the points that fiscal policy will not be as supportive next year and a rate hike is not effective in tempering supply-induced inflation. Lastly, as witnessed, the Bank of England are not and should not be ‘slaves’ to the market, the decisions should be based on the data and analytics to hand rather than what the market is currently betting on. Yes they can and need to communicate better, but that doesn’t equal conforming to the market view to keep them happy.

UK rates ‘yo-yoing’

It’s quite clear which direction rates went in post decision, with swap rates falling as much as 20-25bps off its highs. However within five trading days we were more or less back where we were – a typical knee jerk reaction to a market surprise. One factor of course is, as already mentioned, is the direction of travel has not changed, but the tailwind provided by the move in global rates on the back of the highest US inflation reading since 1990 was the bigger driver – with annual inflation hitting 6.2% in September. Further UK data added momentum to the rebound in rates, however the momentum was short lived as sentiment soured with COVID-19 cases soaring in Europe, leading to Austria announcing a new nationwide lockdown.

The latest US inflation and jobs report is cementing the view that the Federal Reserve will have to raise rates soon after the conclusion of its bond purchases, with markets looking at two hikes in H2 next year. In comparison with other developed economies money market pricing, especially for the Eurozone, the forward curve in the US actually looks the most realistic and where there is a fair bit of consensus, perhaps a testament to the clear communication from chairman Powell…

UK money market pricing over the next year to many still seems overdone and there continues to be a divergence between this and economists forecast – likely exacerbated by the communication difficulties. The market sees Bank Rate rising to at least 1% by year end 2022, down marginally from levels seen last month up until the Nov 4th meeting. Economic headwinds and balance sheet reduction remain firm arguments in favour of a more gradual pace of hikes, but there are upside risks too. Economists’ forecasts, including Handelsbanken, look for something more to the tune of two hikes next year, with Bank Rate ending 2022 at 0.5%. 

One other interesting point to consider when looking at the makeup of the MPC,  especially the two members who voted in favour of a rate hike, Saunders and Ramsden. Saunders’ term at the MPC will end next August and he will leave the committee, whilst Dave Ramsden’s term ends in September and it’s not a given that his term will be extended. We can’t place much weight on this now as it’s a while off and we don’t know who the replacements will be, but it’s another risk to the market view of interest reaching 1% or more beyond 2022 if you take out the two biggest hawks!

The curve, whilst narrowing, is still inverted, meaning the market still sees a chance of a policy mistake. For our clients however it is making longer term hedging look more attractive and many discussions are centering around this, for swaps in particular. If the BoE does not hike in December I would imagine the inversion will narrow further if not fully correct itself. With doubts among some clients on the current market path for interest rates, interest rate caps are still popular – clients with caps in place continue to pay the current low market interest rates on their loan, whilst having the ‘insurance’ protection there at a higher level for peace of mind.

Cameron Willard, Capital Markets

All data, unless otherwise stated, is sourced from Bloomberg