BoE Preview: 25bp Hike With Upside Risk, but Terminal Is Close

Summary

• We expect the BoE to hike the bank rate by 25bp to 5.25%.
• The case for a 50bp hike remains, we assign a 40% probability to the outcome, while the case for pausing now is strengthening, but remains a tail-risk.
• If they were to hike 50bp, we would expect to see it come alongside a strongly dovish tone. As such, we would see value fading any hawkishness that might get priced afterwards.
• The MPR update should see inflation forecasts revised down and unemployment forecasts revised higher.

Market Implications

• We continue to see room for relative BoE dovishness versus the ECB and Fed, which we like via a 2s10s GBP/EUR box and by being short 1Y1Y US OIS vs 1Y1Y SONIA.
• There remains room for 10Y UK inflation swaps to re-anchor to more normal levels.

Inflation Cooling in the UK

In our recent reports on the labour market and inflation reports, we set out why underlying data strongly supports the idea that the UK labour market is continuing to loosen (full-time employment is in decline), that underlying inflation momentum is actually slipping, and that the key drivers of the inflation overshoot are poorly understood, and not representative of second-round effects (Charts 1 and 2).

Note the disparity in this non-wage vs wage intensive driving of inflation between the UK and Eurozone.

25bp Is Probably Sufficient for Now

While our analysis suggests the BoE does not need to hike any further, they will almost certainly do so, given the BoE’s lack of credibility and the embarrassment they would suffer if they needed to restart again. The question now is more whether they will choose to hike by 25bp or 50bp. The market is pricing for around 30bp which looks a bit low. Our base case is for a 25bp hike, but with a fat tail risk for 50bp (prob: 40%). Speaking at Sintra, Governor Bailey, was clear that if they believed multiple 25bp hikes were needed now, they would go 50bp. While the recent data prints has given them room to slow, they should not want to take anything for granted. The risk of embarrassment at having to reaccelerate back to 50bp will no doubt weigh on their minds. Strong wage growth will be something they will be watching closely.

Whether the BoE hikes by 25bp or 50bp, we expect the tone from the updated MPR and that of the Governor at the press conference will be on the dovish side, versus market pricing. GDP and CPI forecasts in the MPR are likely to be softer into the medium-term than previous, on account of the higher rates pricing. And while they are unlikely to talk up the prospects of cutting into the future, if they show strong signs of an imminent pause, the market will probably begin to price such an outcome. We continue to see room for relative BoE dovishness versus the ECB and Fed, which we like via a 2s10s GBP/EUR box and by being short 1Y1Y US OIS vs 1Y1Y SONIA.

Dovish Potential From MPR

The meeting will bring a revision for the BoE’s monetary policy review including its forecasts. On this, we expect:

• GDP may need to be revised marginally upwards for 2023, but probably downgraded further out to reflect the higher priced interest rates.
• The profile for headline inflation will probably be revised down due to higher interest rates and the recent disinflationary trajectory, although continued high wage growth may weigh against this.
• As we have long expected, the BoE will need to revise up its unemployment forecasts to reflect slowing employment growth and strong participation.
• Wage growth has been the biggest fly in the ointment. While surveys continue to predict a slowdown, the overshoot will continue to worry the MPC. The offset to this is twofold:
  • As full-time employment shrinks, wage growth will fall and ultimately become less relevant.
  • Wage-intensive services inflation momentum is sliding, suggesting less pass-through.

In sum, this, and the current survey outlook would suggest to us that the tone from the MPR and the press conference will lean towards the possibility of pausing sooner than the market is pricing. 5.50-5.75% terminal seems reasonable at this time (market at 5.9%), but more importantly the prospect for cutting in 2024 is higher than priced (currently only c.10bp of cuts priced).

Hints on QT?

Last September, the BoE set out their target for total QT for the year-ahead. They are expected to revise this target come September, but there is a chance that they something may hint at something at the press conference this week. They are expected to revise this target come September, but there is a chance that they may hint at something at the press conference this week. Maturities will accelerate in the year-from-September, the question is whether active sales will stay at their same rate (an acceleration in total QT) or drop back.

The BoE will probably continue to identify its bank rate as the main source of policy changes. However, it is not beyond the pale for them to highlight a potential acceleration in total QT as supporting fewer hikes ahead. We will be listening closely for any such suggestion.

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)