Rates remain stubborn as MPC split intensifies

May 2022

The Economist’s Corner

War and inflation keep everyone guessing

A year ago, the Bank of England’s forecast anticipated that inflation would be at around 2.5% at this point and fall back to its 2% target by the end of 2022. But a combination of tax increases, including the return of VAT rates to pre-pandemic norms, energy price hikes, and supply chain difficulties, dramatically altered expectations. We now expect inflation to peak at 10% percent in the fourth quarter of this year. Further increases in the cost of domestic energy are already set for October, the result of which means that we forecast inflation to only fall to 8% by year-end.  

Looking beyond 2022, we see cause for caution about the prospects for inflation, but not cause for despondency – caution because core inflation is now registering at 5.7%. At the same time, much of UK inflation in 2022 will be tied to energy prices, and even if energy prices do not revert to levels seen in 2019, further dramatic rises are unlikely, and thus, due to the base effect alone, we should see inflationary pressure begin to subside in 2023. Moreover, wage increases, while high in nominal terms, are 1% below inflation, according to latest ONS figures. A tight labour market, evidenced by an unemployment rate of just 3.8%, is naturally contributing to wage pressure, but there should be some upcoming relief for the labour market, as around 500,000 workers who have remained inactive since the onset of the pandemic can be expected to re-enter it over the course of 2022. Overall, we expect unemployment to rise modestly in the coming two years, peaking at 5.5% towards the end of 2023.

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Action on Inflation 

That said, the Bank of England clearly has to act, and financial markets now expect base interest rates to be above 2% within the next year. This would put interest rates close to what is thought by academics to be their “neutral” level, a rate that is sufficiently high to counter inflation, but not so low as to encourage asset bubbles or mal-investment. While such a move would meet the Bank of England’s mandate to counter inflation, we believe such a rapid move to these levels would likely trigger a recession. Therefore, we forecast that the Bank of England will be more cautious and raise rates to 1.5% in two more 25bp steps in August and December. Thereafter, maintaining interest rates at that level would be consistent with a ‘soft landing’.

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Raising interest rates to a level below ‘neutral’ does not mean there will not be a further tightening of monetary policy, and our forecast is that the Bank of England’s preferred path will be to cautiously continue with Quantitative Tightening (QT). This will be achieved primarily by not reinvesting the proceeds of the Asset Purchase Programme (APP) stock of debt as it matures (a process already started in March, as interest rates rose above 0.5%). Simply not reinvesting the proceeds of the APP gilts as they mature would result in a reduction of 20 percent of the APP stock of holdings by mid-2025 and 50% by 2030, although the final holdings would not mature until 2070. If necessary, the Bank of England has indicated it may speed up the process by additional targeted sales of its stock of assets (active QT), now that interest rates are above 1%. Given the limited global experience with any form of QT, let alone active QT, the Bank of England will no doubt be proceeding cautiously.

James Sproule, Chief Economist

A view from the dealing desk

Puzzling market remains stubborn

The market reaction to the latest Bank of England decision was rather intriguing to say the least. Whilst the move to 1% was expected, the initial spurt of volatility was in reaction to a hawkish surprise in the form of 3 dissenters, Michael Saunders, Jonathan Haskel and Catherine Mann voting for a higher 50bp hike. Rates moved higher very briefly as the market was positioned for one or two hawkish votes, they were also caught about by the decision of Jon Cunliffe who this time voted with the majority to raise rates to 1%, after dissenting in the March meeting in favour of keeping rates on hold at 0.5% at that time.

As far as hawkish surprises go however, this was about it. As snippets of the statement filtered through it became quite clear that this was indeed another ‘dovish hike’. Forecasts were updated which now show inflation peaking above 10% in October after another OFGEM price cap increase, but more notably the MPC sees the economy shrinking marginally in 2023 by 0.25%. Notwithstanding the fact that this clearly illustrates the economy is on rather fragile footing, this also shows that the central bank clearly does not endorse market expectations for interest rates.

The economic forecasts are based on the market-implied path for interest rates over the given term, where pre-meeting the peak was seen at 2.5%. With rates accelerating at that pace, the Bank of England sees this impacting the economy negatively, albeit marginally, through its impact on consumer borrowing (higher cost of finance) and the housing market (lower prices). All else being equal this implies that there is enough spare capacity for rates not to increase another 1.5% in 12 months. This view is in tune with one or two members of the committee, likely Mr Cunliffe and Silvana Tenreyro, who see no more hikes as appropriate in the coming meetings according to the minutes.

Market rates then took a dive in the hour after the midday decision, as one would expect, falling 10-20bps across the curve with shorter maturities falling the most – but again like with the previous dovish hike it didn’t last long! By late afternoon, rates not only moved back to the pre-meeting levels, but exceeded them, puzzling myself, the team, and a large majority of forecasters out there. Even the FX market, where interest rates play a huge part in determining the value of a currency, diverged with the pound falling heavily against the USD and EUR.

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Three factors are likely at play in explaining why, rightly or wrongly, market rates have remained stubborn and have actually moved higher. Number one is continued concern over the path of inflation, the October peak of 10.2% is a scary number and this alone could justify the need for rates to accelerate further. The market may be of the view that it is necessary for the Bank of England to hike the UK into recession in order to bring down inflation expectations that are elevated, which helps reduce or eliminate the potential for any spiral in wage demands.

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The market may also be pricing in a strong chance of stagflation, where inflation remains elevated despite a shrinking economy, which could be possible should further escalation of the war in Ukraine continue to impact the available supply of commodities (through a loss of supply or purchase embargos) or if supply chains remain disrupted for longer.

However, the forecast for inflation in 3 years’ time is expected to be well below the 2% target at 1.3%, suggesting that a combination of weaker demand and base effects will help lower inflation naturally – Base rate at a peak of 2.5%, will only exacerbate the fall in inflation to a level way below target. Some context around the forecast is also needed here, the current inflation forecast is heavily weighted on the price of oil, which the MPC incorporate the current futures curve for the next 6 months, but assume that prices remain constant thereafter. If global demand starts to falter as many expect then this would suggest that oil prices could fall further than what the current futures curve is pricing in.

The second factor at play could just be that the credibility of the Bank of England may be so fragmented that the market does not place much weight on what they say - the communication mishaps of last winter have not been forgotten. The BoE themselves will be the first to say too that outlooks can change very quickly in the current climate with new data that comes in.

The third and the most likely factor is the global tailwind behind higher rates that we see currently, in particular from the US. Indeed, the marginal fall in rates in the days after the BoE decision are in line with falls seen in US Treasury yields. In the previous rate wrap I mentioned that we should see a divergence between UK and US rates, but the extent and timing of this remains unclear and currently moves in US are putting a floor under rates in the rest of the world.

The Federal Reserve raised rates by 50bps at the start of this month as expected to a band of 0.75-1.00%, and announced the first stage of its balance sheet reduction, which will start reducing by $47.5bn a month and increase to $95bn in the coming months. Some participants were disappointed in Chairman Powell’s comments that 75bp hikes are not actively being considered, but it seems likely that we will see successive 50bp hikes over the summer. Consequently there is a gap opening between the UK and US interest rate expectations over a 12 month horizon as shown in the chart below with the latter exceeding 3%, and I would expect that gap to increase as the US hiking cycle lasts longer with inflation appearing very sticky.

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We are keeping an eye on the Eurozone too where a rate hike appears to be imminent. Officials seem to be looking at a July hike although some hawks are calling for action in June. The European Central Bank have some catching up to do so the initial hikes will not mean too much for the market or UK rates in particular, but again perhaps due to the geographical proximity and exposure to Russia (relative to the US) we need to pay more attention to the ECBs plans for rates later this year and into next year. 

The ECB at some stage will be concerned with wider spreads between core (German mainly) debt and peripheral debt like Italian and Spanish bonds, and core inflation at 3.5% is higher than target but not at the 6%+ level like we are seeing in the UK and US – therefore I believe the market has also gone too far in the pricing for rate hikes in Europe also.

What happens in June?

The June 16th meeting really now is key, as the outcome remains rather uncertain at this point. In the previous three meetings the market has expected a hike in rates, but another 25bp hike in June is not guaranteed even if the market expects the MPC to follow through with another increase. One thing that is certain is that we will have no news on the BoE’s plans around asset sales to further reduce its balance sheet – it was noted in the May meeting that further updates will be provided in August.

We have not had a committee this split in a long time and its plausible that we could have a three way split, potentially two in favour of keeping rates hold and one or two members, like Saunders, again voting for a 50bp hike. This all assumes that Bailey, Pill, Ramsden and Broadbent all continue to favour a small hike. For Pill and Ramsden this looks nailed on judging by post meeting comments, where the latter explicitly stated that he is “supportive” of the forward guidance that further tightening may be needed. The summer meetings, June and August, could potentially be the pin that bursts the balloon and causes a significant repricing lower of short and long term rates if the Bank of England surprise the market by keeping rates on hold, and then is further backed up in August by forecasts remaining gloomy and a cautious, flexible approach to selling assets. 

This however is not a base case, and most economists and forecasters still say one or two hikes are still needed, so the “bursting balloon” moment may get pushed into the autumn instead where personnel on the MPC will change too, but either way we go into the summer meetings with more uncertainty than ever. Combined with lower liquidity, this is fertile conditions for more market choppiness.

As the gap closes between base rate and longer term swap rates activity is picking up, with more hedging being done via swaps. Despite the fact that Cap prices increase with volatility, which we have in abundance, Caps are still proving popular. Customers who have doubts around market expectations for rates are favouring caps given that they continue to pay market rates whilst also having the insurance-like protection in place should rates shoot higher.

Cameron Willard, Capital Markets

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

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