Surprise hawkish pivot from the Bank of England

The Bank of England’s Monetary Policy Committee (MPC) cut base rate in August but the vote was more hawkish than expected as the bank raises its near-term inflation forecast. Given supply side improvements could be some way off, this points to upside risks on inflation and bank rate pathway. 

In advance of August’s MPC meeting, it had been thought that a rate cut was “a dead-cert”. Markets had expected a two (0.5pp cut) – five (0.25pp cut) – two (freeze) vote split, yet while base rate did come down from 4.25% to 4%, the vote breakdown was on a knife-edge. Four members voted to hold rates while five argued for a 0.25pp fall in rates (with one member Alan Taylor initially calling for a 0.5pp cut). 

This signifies a notable hawkish pivot on the MPC. The narrow majority of members backing a rate cut used continuing evidence of labour market weakening to justify their votes, although there remains a difference of opinion among these members about how fast this will be reflected in disinflation of services inflation and wage growth. However, as previously stated, four MPC members felt unable to ease the restrictiveness of monetary policy at this meeting. These members are placing much more emphasis on the risk of second round effects arising from the elevated headline rate. Even before this meeting, UK inflation was expected to be north of 3% until at least April and the Bank of England has now somewhat revised up its inflation forecast. In particular, the near-term forecast has risen, meaning there is now likely to be a peak in y-o-y CPI of 4% later this year, and this is being accompanied by signs of consumer inflation expectations becoming unanchored. 

Since the MPC vote, we have had Q2’s GDP print which registered at 0.3%. Even though this was better than markets had expected, it does not seem to be anything to shout about given that the upside surprise appears, at least in part, to be driven by higher-than-expected government spending. All signs continue to point to a year of below-trend growth, and there continues to be disagreement about whether demand or supply factors are driving these growth dynamics.

In terms of improving future growth prospects, two factors are often cited as sources of a potential boost to the productive potential of the UK economy: planning reform and the adoption of artificial intelligence (AI). It would seem advisable to exercise a degree of caution regarding the short-term impact on the supply side from either of these factors. First, there definitely appears to be some over-optimism about improvements. For example, the Office for Budget Responsibility’s current forecast of planning reforms helping to boost house-building to 300,000 new homes a year by the end of the decade seems a stretch. Moreover, any improvements that do take place will have a reasonably long lead time. It is notable that a recent study from the OECD suggests that only 2 – 6% of businesses in the G7 have adopted high-intensity use of AI, highlighting that its benefits are currently confined to a small number of sectors.

The MPC’s latest hawkish pivot coupled with the fact that any supply side improvements will take time to filter through into the economy suggests upside risks to both inflation and the path of interest rates in the UK in the shorter term. Prior to the August rate decision, markets had fully priced in another rate cut this calendar year but, as of 29.08, the chances of this happening have fallen to below 50%. Look out for Handelsbanken’s latest economic forecasts for the UK and global markets which will be published on 10 September.  

Daniel Mahoney, UK Economist

There has been no summer holiday for markets, as central bank decisions and surprise data releases have been peppered throughout August, along with a sprinkle of geopolitical headlines for good measure. 

Kicking the show off at the end of July was the European Central Bank, which held its target rate at 2%, as widely expected. After seven consecutive 25bp rate cuts and 200bps of easing since September 2023, it is generally expected that the ECB is nearing the end of its rate cut cycle, with 1.75% still largely anticipated as the landing zone for the policy rate. With inflation in many regions such as Spain bang on the 2% target, a slight undershoot was a risk that ECB President Christine Lagarde played down with a medium-term outlook being the key driver for policy. The ECB’s June projections included a terminal rate of 1.75%, but the question of when is a point of contention. At time of writing, a 1-in-5 chance of a September cut is currently priced in, with more conviction (but still not fully priced in) for a rate cut Q1 next year.

Shifting focus to the UK, as Daniel talks about above, the Bank of England delivered a 0.25% cut to base rate as expected, however the hawkish pivot from the MPC resulted in a repricing of rate expectations. Pre-meeting, a further cut this year was priced into November’s meeting, and almost fully priced in to December (96% chance in December), which would bring base rate to 3.75% by year end. The meeting on 7 August however flipped this on its head. 

Votes had to be recast as no majority was reached originally – the first vote was 4-4-1 (4 hold, 4 cut by 25bps, 1 cut by 50bps). MPC member Alan Taylor initially voted for a 50bp cut, and changed to a 25bp cut in the second round of voting in order to secure a 5-4 majority to cut. Four members including Chief Economist Huw Pill favoured no change, and initial market reaction saw the 2-year swap rate jump 6 basis points. The minutes from the meeting suggest that elevated inflation expectations were the key motivator behind the four no-change votes, with particular concern around food inflation remaining elevated. A key change to note is a shift in the Bank of England’s short-term inflation forecast, which saw a tweak to expect inflation peaking at 4% in September this year, previously cited as 3.7%. Despite this, the language of the minutes clearly indicates that policymakers favour a slower pace of easing instead of an end to the rate cut cycle. 

In terms of swap rates, across the curve rates have drifted upwards throughout the month, but have stabilised around mid-August. Notwithstanding the sharp drop in rates following the US payrolls undershoot, where we saw a 10bp fall in swap rates (which is explored later on), if we compare the open on 1 August to the time of writing, 10-year swap rates are up around 5bps across the month. 

Some easing has been priced in across the curve, but the lack of sharp correction upwards to rates following the policy announcement reflects the fact that rate cuts aren’t completely off the table, but instead the can has been kicked down the road by the MPC. There is now only a 54% chance of a December cut priced in (at time of writing), with a cut now seen more likely in February.

One of the big news stories of this month was the US non-farm payrolls – the first Friday of every month, US jobs figures are released, and this is always widely anticipated because it’s considered a snapshot into the overall health of the US economy. 

The relatively modest July reading of 73k (gain in payrolls) was not a showstopper on its own, despite undershooting the consensus of 104k, but it was the combined downward revision of 258k to the May and June readings which was the surprise. The monthly gains after the revisions showed an increase of less than 20k each, and shines a different light on the state of the US economy. Taking into account the revisions, the overall trend indicates that the US jobs market has lost momentum, which has heightened expectations that the Federal Open Markets Committee will cut rates in September. Not only that, the unemployment rate ticked up to 4.2%, a figure Fed Chair Powell has touted as important. The Fed held rates between 4.25%-4.50% at its meeting on 30 July, which was as-expected, but pricing now points to over an 80% chance of a cut in September, up from less than 50% before the payrolls figure was released.

US Treasuries rallied after the non-farm payrolls release, which reflected a shift in bets that the Federal Reserve will now look to lower interest rates at the next meeting. 2-year Treasury yields fell 17bps to 3.79%, and 10-year yields fell 9bps to 4.29%. The old saying from after the 1929 Wall Street crash rang true that “when America sneezes, the rest of the world catches a cold”, as we saw this fall in yields ripple through to UK gilts, with the 10-year gilt yield moving 10bps lower to 4.53%. It is not uncommon for these two assets to track closely, and UK gilts retain their spread over US Treasuries. This is reflective of the associated risk premium with UK gilts, and the sustainability of the UK debt profile as Daniel and Cameron spoke about in July’s Rate Wrap.

President Trump fired the head of the Bureau of Labor Statistics after the results were announced, a shock move that saw an accusation that the BLS’ release was “manipulated for political purposes”. The move saw lawmakers and economists alike raise concerns over the integrity of the data going forward, which was met by criticism from the Democrats. This echoes the calls from Trump for Federal Reserve Chair Jerome Powell to be removed from his post for not lowering interest rates, and the payrolls release will no doubt add to mounting pressure on Chair  Powell. Not only that, the story continues to unravel following Trump’s firing of Fed governor Lisa Cook on allegations of false information on mortgage applications (the saga is ongoing at time of writing)

There is a sense of déjà vu, as I wrote in the August 2024 Rate Wrap about the impact of payrolls undershooting expectations, along with higher unemployment triggering a fall in US interest rate expectations and lower yields. The difference this time around is that last year a 50bp rate cut and an emergency rate decision were thrown around, along with an increase in volatility in equities. This year is a lot less dramatic, with the US stock market continuing its post-tariff announcement surge. However, the continued pressure President Trump is applying to the Federal Reserve and its future independence, alongside US economic statistics is a bit of a question mark that market participants are not putting much weight behind currently.

Jasmine Crabb, Handelsbanken Markets