Key questions on the UK recovery as the Bank of England holds tight, whilst the Federal Reserve surprise sparks “some” life into the rates space

June 2021

The economists corner

As always, the economy gives us plenty to think about and there are three key questions going forward: 

What is going to drive the recovery over the next year?

Every economic forecast has a degree of uncertainty, but encouragingly there is less doubt in today’s forecasts than normal. Much of this is down to my expectation that the biggest driving force of the expansion is the redirecting of existing income from forced savings to consumption. I am making no heroic assumptions about the desirability of a new product, or forecasting that people will take on more debt; I am merely assuming that as people are allowed out, they are going to want to return to something like normal. Alongside the big boost to consumer expenditure, I am also looking for a reasonable rise in business investment. Brexit uncertainties have been allayed and with consumer habits changing as a result of the pandemic, businesses have the necessary savings to respond to new demands. 

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When and how will the economy slow?

The UK’s long run annual trend rate of growth before the pandemic was some 2 percent. Forecasts vary but the overall economic growth for 2021 could be over 7 percent. Clearly the present rate of growth is not sustainable, thus a good deal of slowing of the pace of growth is going to happen over the course of the coming year. I also do not expect to regain the economic activity that we have lost since March 2020, such a move would require consumers to spend a significant portion of their accumulated forced savings. That said, even accepting a gradually slowing of the pace of growth will take us to the level of GDP seen at the end of 2019 by the end of this year or the beginning of next. This slowing will see consumer spending normalise and the business investment spree runs its natural course. Key to my assumption is that interest rates remain at or near their present low levels.

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Is inflation a threat?

There is a growing concern about inflation, and we are certainly seeing more inflation recently than we have seen in some years. Much of the recent rise is down to two big effects: we are measuring today’s prices against the depressed prices of the first lockdown (what is known as the base effect); and pent-up demand is hitting businesses which are not always able to cope, so they are putting up prices (what is known as friction). Both these impacts should naturally lessen over the coming year, with the result that inflationary expectations should remain ‘anchored’, that is consumers will not build inflation into their pay expectations and they will resist price rises in shops. Longer term there are concerns about the impact of the creation of vast amounts of money (not solely a UK problem) and many governments running staggering deficits. This is indeed a reasonable concern, but it is not one which has yet manifested itself in inflation. 

James Sproule, UK Chief Economist

A view from the dealing desk

June was dubbed to be a big month for the rates market, given the low volatility environment that took control in May. We first had US inflation printing a 5% year-on-year, yet the reaction was short lived. The European Central Bank meeting on 10th June proved to be a non-event with no changes to the commentary. The Federal Reserve meeting on the 16th however did conjure up some market volatility via the hawkish surprise in the forecasts, or more commonly known as the “dot plot”. The median forecast now shows two rate hikes in 2023, with 11 of the 18 members forecasting more than one.

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Not only this, but the Fed finally confirmed that an initial discussion was had regarding the tapering of assets, the first step towards a formal announcement which many expect to come in September. Looking at the market reaction this time, it was rather different, rates in the two year and five year segments (the “short end” and “belly” of the curve) have remained elevated, whilst those further out have reverted back to pre-Fed meeting levels.

The rationale for the “curve flattening”, which was also evident in UK rates as highlighted in the chart below, is clear. Central banks are bringing forward the timeframe for interest rate rises and that has helped lift five-year rates. This therefore reduces the scope for further increases needed longer term, bringing down 10-year rates, which is exacerbated by lower inflation expectations longer term as a faster normalisation of monetary policy will work to dampen that inflationary pressure. Admittedly, rates in five years have since tailed off, although still remain above levels on 16th June.

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Bank of England holding tight for now

Despite events across the Channel and the Atlantic taking centre stage this month, we have also had a meeting on Threadneedle Street, the last for outgoing Bank of England chief economist Andy Haldane. Mr Haldane, the most hawkish member of the committee has been keen to express his views on the recovery in the UK and the inflation we could witness, evidenced yet again by his voting to reduce the asset purchase envelope again by £50bn. 

There were no major surprises in the commentary, although some attention was paid to the comment that inflation will exceed 3% temporarily. However, the rhetoric that inflation will be transitory remained clear, despite conceding that short-term inflationary pressures may be larger than expected.

There was some focus on another MPC member, Gertjan Vlieghe, and whether he would move into Haldane’s corner. Vlieghe, previously viewed as a “dove” in the camp, caught markets off-guard back at the end of May in a speech given to Bath university on his projection for the future path of the BoE Bank Rate.

In the speech, Vlieghe concluded that based on the his central scenario the first rise in the BoE Bank Rate would be appropriate “well into next year”. At first glance this portrayed an unusually hawkish message and a more concrete sign that the central bank may be moving towards current market pricing of a late 2022 hike. Admittedly, after reading the speech transcript I think the comments were taken a little out of context, and in fact Vlieghe mentions that his central scenario differs minimally from that of the MPC’s central forecast, but that he actually fears a modest rise in the unemployment rate. The chart below shows Vlieghe’s scenarios for the Bank Rate over the next three years.

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With all that said, the spike in rates was imminently reversed I must point out. Perhaps rightly so given that Vlieghe’s term at the central bank comes to an end in September, which makes his view somewhat less impactful on the market, but who’s to say the others aren’t sharing a similar opinion? Vlieghe is to be replaced in September by Citibank chief economist Catherine Mann, who is not expected to shift the balance of the MPC. Haldane’s replacement is yet to be announced.

Rates on the move, but historically speaking still attractive

Despite the uptick we have seen, the curve still offers attractive levels considering the expected direction of travel and when looking back historically. This is reflected in continued and growing interest in hedging solutions, where interest rate caps are still proving very popular by providing a known capped interest rate whilst also being able to take advantage of lower market interest rates in the short term.

The latest meeting proved to be a scene-setter, in future months it will be interesting to see whether the “Old Lady” follows the more decisive path taken by its peers in Norway and Canada, and now the Fed, or if it remains cautious like its friends in Frankfurt – I sit in the former camp currently, but two-way risks are evident, especially with the growing case numbers and the prominence of the Delta variant.

Cameron Willard – Capital Markets

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