From summer smoothness to autumn action

UK economy is heading into a cooler autumn

Looking at the economy overall, there are growing indications that the UK economy has now achieved the vast majority of its recovery, even if the economy is still some -2.5% short of the level of GDP seen at the end of 2019 (ONS). Supply constraints are clearly a good deal less transitory than initially anticipated and while surveys such as that of purchasing managers are still positive, they are down from the heady figures seen at the start of the summer. The good news alongside this is that the latest ONS business conduct survey shows that employment levels continue to improve, and our forecast is that even with the end of the furlough program, we are unlikely to see unemployment rising above five percent anytime soon. More generally our expectation is that over the next few months a number of concerns that were at the forefront of people’s minds before the Covid pandemic are going to re-emerge: from sluggish productivity, to putting in place a long term plan to deal with excessive debt, to inflation. For the Bank of England and people who are concerned with rates more generally, the key remains inflation. The Bank remains of the view that much of the 3.2% inflation reported for August is transitory (in particular the restaurant meals impacted by the base effect of Eat Out to Help Out), compounded by issues such as transportation bottle necks (which are fading more slowly than initially expected). But concerns remain, in particular that wage rises of 8% plus seen over the last two months prove to be stickier than anticipated.

The impending battle on the Monetary Policy Committee

In their most recent meeting the Bank of England Monetary Policy Committee voted unanimously to leave interest rates at 0.1% and the Bank will be continuing with its £895bn program of Quantitative Easing through to the year-end. In their previous August meeting, and in the absence of former BoE Chief Economist, Andy Haldane, we had seen Michael Saunders take up the hawkish mantle and vote to reduce the pace of the QE program. Saunders has now been joined by Dave Ramsden, although the BoE’s new Chief Economist, Huw Pill, who is seen as potentially hawkish, for the moment agreed with the majority that the QE program should continue until the end of 2021. Undoubtedly both dissenters knew that they would be outvoted on this occasion, but they are keen to put down markers that monetary policy should be rebalanced over the course of 2022. Indeed the minutes of the meeting noted that modest tightening over the forecast period was likely to be necessary. A good number of commentators had been expecting this tightening (to 0.25%) to commence sometime in 2022, my view has been that any tightening looks more likely in mid-2022 at the latest, a view that is likely to be increasingly the consensus as the autumn progresses.

The Fed is on the move

At the end of August we had the highly anticipated Jackson Hole Symposium, where markets were looking for a more concrete timeline on the Federal Reserve’s plans to reduce stimulus. Markets however were perhaps left disappointed: whilst Chairman Powell acknowledged that tapering could start in 2021, the focus of this segment was more to try and de-link tapering to subsequent interest rate hikes – which in all honestly the market is still a little sceptical of.

The September Fed meeting did provide more meat for the market to chew on, given that it included an update to the members’ forecasts, or the dot plots as it’s known. All in all the forecasts were more aggressive, with half of the members now calling for a rate hike in 2022, and the median forecast for 2023 now shows the Fed funds rate rising to 1.0% from 0.6% previously. Jay Powell also revealed that the economy will be on a firm enough footing to announce a taper it its November meeting, which is now the market consensus. US money markets are indicating a first rate rise between September and December 2022.

On a slightly separate note, things are heating up in the discussions on whether Powell will get a second term at the helm of the Fed. Lael Brainard is closing the gap in the betting markets after Senator Elizabeth Warren announced she would vote against Powell’s reappointment, calling him a “dangerous man” – one to watch.

New man on Threadneedle Street

As explained in The economist’s corner, the BoE kept its message the same in its September meeting. Given it has only been a month since its last full report, and new chief economist, Huw Pill, still needs time to settle in, it’s not surprising that he, and the bank, are keeping their powder dry. 

The appointment of Huw Pill in many ways seems like-for-like replacement of Andy Haldane. Mr Pill will likely sit in the camp of the hawks, as that is how he has been described by his former colleagues. Pill in published research has called for limits in the use of unconventional tools which includes QE. He will likely join his new colleagues Michael Saunders and Dave Ramsden in that camp when contributing to future decisions, likely dissenting in the vote to keep the QE target at £895bn.

Ultimately, the appointment of Catherine Mann and Huw Pill this autumn will not change the dynamics of the committee. In our draft of this piece before the BoE meeting, we mentioned more interest should be paid to Dave Ramsden considering some of the hawkish tones we have witnessed, and well, we now know that proved to be correct.

All action in UK money markets

One development which has taken many by surprise is the action seen in UK money markets where at least three rate hikes are now priced-in for 2022. Looking more closely, the market sees with some conviction a first hike in Q1 of next year taking the BoE Bank Rate to 0.25%, whilst a further 25bp hike to 0.5% is pencilled in for around Q3. Money markets also place a fairly high chance of a third hike by the end of 2022, and even a small possibility of the first rate hike coming this year! The move succeeded the higher inflation print from August with the headline figure at 3.2% (see The economist’s corner above), with this being the catalyst for other analysts in the City to change tune. Goldman Sachs has updated its forecast and now sees the first hike in May 2022, with the BoE Bank Rate at 1.0% by Q4 2023.

The inflation debate, transitory versus stickiness, continues to rumble on and we shall not revisit this subject again, but put simply a good chunk of the 1.2% increase in the headline figure was indeed due to comparing prices today against depressed prices a year ago (Eat Out to Help Out) however it cannot explain all of the increase. Most analysts and the BoE expect to see the headline figure at over 4% in Q4’21 and Q1’22, when we add in the Ofgem energy price cap increase of 12% in November and the full reversal of the VAT cut in selected sectors. However the BoE, like most other central banks, including the Fed, are looking through these elevated levels and focusing on the outlook of medium term price pressure.

Energy prices are a growing concern as they continue to surge. A lack of wind over the summer, supply issues in natural gas markets and a fire in a power cable between the UK and France are the main culprits. UK gas prices in the futures market for the nearest possible delivery have increased exponentially over the past six months and are showing no signs of let up as we approach the winter. This is not just a UK problem, but increasingly more acute compared to elsewhere.

Given the way Ofgem calculates its price cap, analysis from Pantheon Economics suggests that we could see another rise of as much as 26.5% in the cap next April. This does add fuel to the ‘stickiness’ side of the inflation debate if elevated prices stick around for longer (which in the medium term may be exacerbated by the transition to greener sources) feed into higher consumer inflation expectations. This said, it should not be interpreted that this means inflation will necessarily continue to rise, but that it will just take longer to ‘normalise’ – at least that’s what the experts say…

Moving away from economics and back to the rates market, and more importantly the swap market – with the above move in money markets in mind, it is unsurprising that we have seen a sizeable shift higher over shorter tenors, with a big move in the two-year swap rate to 0.55%. However longer tenors have also moved higher, with five-and 10-year rates reaching to 0.76% and 0.92% respectively. These are not dramatic levels considering where they were pre-pandemic, but they have been climbing rapidly reaching year-to-date highs.

Despite the perplexing picture painted by the rates market over the summer, taking a look back over the year now we have tried to paint a more simplistic picture of the pattern we have seen:

Phase 1: A recovery-induced jump in rates in Q1 as the economy opened up and the vaccination programme got underway. This was followed by a plateau/decline over the summer – Phase 2.

This plateau/decline was initially down to the over-exaggerated move in February and March, but the extension over the summer can be seen as traders holding fire on further bets to wait and see how the central banks would react. This reaction would take time in order to digest data and trends, before communicating their next moves, which we are now starting to see. If the central banks take a hawkish stance, as many have, including the BoE, then the rates market has a catalyst to push higher again – Phase 3?

This three-part move in 2021, we repeat, is a very simple way of looking at it, other factors have been at play, but broadly speaking this is how the desk may have anticipated developments playing out. We however do not expect rates on longer tenors to rise significantly unless economic data surprises again to the upside.

This current move higher in rates is only in its early days and we know it can easily change course. we do believe that this (initial) UK-specific move in the money markets following the inflation print seems a bit overdone. We maintain the view that the BoE will try and stick to the same tune that is being sung from the Fed, despite, we must stress, them being at different stages: The BoE’s asset purchases are coming to an end whilst the Fed continue to buy (although soon to be at a slower pace). This means that the BoE is more likely to raise rates before the Fed – but it doesn’t mean that they can’t move at the same pace. It seems a bold play from the money markets given some of the headwinds we may see play out, and considering inflationary pressures in the US seem much stronger and likely to last longer.

But then again, they may prove right!

Cameron Willard & Charlie Neil, Capital Markets

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