BoE Preview: A Final Hike?

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Summary 

• We expect the BoE will hike by 25bp to 5.5% and signal that they are ready to pause thereafter. 
• Recent data and the tone of policymakers have set the groundworks for such an outturn. 
• Fundamentally, we believe the BoE could have paused hiking much sooner but chose not to on the back of one-off data surprises and a lack of credibility. 
• On QT, there is room for an acceleration in gilt sales. We expect £45-50bn, but there are upside risks here given that the BoE may choose to accelerate further to offset rate declines in the 2-5Y space (which drives mortgage rates). 
• We retain the view that if the BoE was to skew its selling towards any specific buckets, it makes sense for them to skew towards the 5-10Y space. 

Market Implications 

• We continue to see good value in 2s10s GBP steepening outright and vs EUR, and by being short 1Yx1Y US OIS vs 1Yx1Y SONIA 

Current BoE Forecasts 

Link to Most Recent BoE Meeting Minutes 

One Final Hike, Then Pause 

We have been dovish on the Bank of England (BoE) for some time. This case has been helped by the most recent labour market and inflation prints. At the September meeting we err towards them hiking the bank rate by a final 25bps to 5.5% and indicating that they should be able to pause and hold here. There is a high risk of no hike this week given the recent path of inflation and surprises to the downside in data, but we see this as more likely to come in November, when they update their forecasts (Charts 1 & 2). 

Since February, we have warned that BoE forecasts looked overly optimistic on unemployment). Given UK household weakness, compounded by the rise in unemployment, our belief is that the BoE could have done a lot less hiking to bring inflation back down. However, a lack of credibility kept them hiking on the back of repeat one-off surprises in inflation.  

The need to react strongly to headline inflation misses appeared to change at the last meeting, with the adoption of a more detail-oriented data focus. This week’s inflation print provided further strong dovish evidence. Governor Bailey warned earlier in the month that they would look through rises driven by one-offs, so too we expect will they be wary of one-offs to the downside (air fares and package holidays missed, and the drop in accommodation price is hard to extrapolate). The detail of the release is most important, and it shows slowing inflation in wage-intensive services sectors. The question is whether the BoE feels now it is comfortable enough on inflation to allow mortgage prices to fall (i.e. 2-5Y rates to decline). We expect not, as such they will probably not want to surprise the market with a pause.  

More broadly, we continue to see good value in 2s10s GBP steepening outright and vs EUR, and by being short 1Yx1Y US OIS vs 1Yx1Y SONIA. These trades have performed very well since inception and are close to our targets. But there is room for them to go further in the near-term. 

The BoE Could Accelerate Short-End Gilt Sales 

The BoE will announce its decision on the path of gilts sales over the next 12 months. At their September 2022 meeting, they set the wind down of gilt holdings over the next 12 months at £80bn (£40bn in maturities, £40bn in sales). Over the 12 months from their upcoming meeting there will be around £50bn in maturities, but there is still room for an acceleration in active sales. The rationale for this is that with corporate sales completed, there is room for more of the sales to fall on the gilt portfolio, alongside the fact that last years’ sales were completed in a slightly shorter-than-planned 11 months (due to the delay from the budget debacle). 

At this stage, an acceleration to £45-50bn in active sales would not be unreasonable (Chart 3). There is probably upside risk to our assessment for several reasons: 

• While the BoE would rather not refer to its QT as its main tool of use, it has also been far more explicit about the ‘rate hike equivalent’ of QT than the likes of the ECB. As such, it could take up the mantle when hikes stop. 
• In laying the ground for pausing hikes, the BoE is opening itself to relative strength in the 2-5Y space on fewer hikes being priced. This is the area that drives pricing for mortgage rates. Greater QT could reduce this impact. 
• The BoE may feel the need to more quickly normalise its balance sheet (sub £500bn). 

There is little expectation in the market for a change in the distribution of sales across the buckets (short: 3-7Y, medium: 7-20Y, long: >20Y). However, there are cases for such a change. If they were to do so, we would lean towards them selling proportionally more in the 5-10Y space. 

• A skew in sales towards the long end would allow for a bigger duration hit, and also force the UK government to bear larger costs (and with it, squeeze fiscal headroom). However, as the UK government does not look to be particularly fiscally expansive right now, this would be a politically clumsy move with little tangible gain. 
• We lean more towards a skew in sales towards the short/medium buckets on the back of our recent analysis of the composition of APF holdings (Chart 4). The rationale is that if it does not, the BoE is set to end up with a disproportionate amount of its holdings in the short bucket in coming years. As such, it makes sense for them to sell more heavily in the longer-end of the short-bucket and shorter-end of the medium-bucket to balance things out (the 5-10Y space). That would also maintain pressure on mortgage rates without causing any upset in less liquid parts of the curve. It is on this basis that we see value in 2s5s steepeners. We would reassess the situation if the QT profile is materially different from our expectations. 

Recent Voter Comments

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.)