This article is only available to Macro Hive subscribers. Sign-up to receive world-class macro analysis with a daily curated newsletter, podcast, original content from award-winning researchers, cross market strategy, equity insights, trade ideas, crypto flow frameworks, academic paper summaries, explanation and analysis of market-moving events, community investor chat room, and more.
Summary
- Whether the BoE cuts rates this week is highly uncertain. The fundamental picture suggests they should cut immediately. But recent data volatility could lead to another pause.
- Updated forecasts could be key (even though med.-term ones will get caveated). If they realign near-term CPI downwards, it will strongly justify a cut.
- Ultimately, our stronger view is that the UK inflation dynamic is much weaker than the BoE (and market) assumes.
- Comments are likely to concentrate on the fact that a reduction in bank rate from 5.25% does not mean policy is easy.
- They will likely push back on the idea they are now cutting back-to-back. However, if the data develops as we expect, this is not beyond the pale.
- We do not expect an imminent QT winddown, but government pressure to slow sales is likely to build ahead. If they are expecting to slow sales at the Sep./Nov. meetings, we may hear some comments laying the groundwork.
Market Implications
- We continue to like to add to dovish UK positions, especially versus the US (40bp more Fed easing than BoE priced over next 12 months):
- We like short Z4 SOFR vs long Z4 Sonia given market pricing still appears overly dovish in the US
- We like long 10Y UK bonds targeting 3.5%.
BoE Should Cut – But Will They?
We have long argued the UK medium-term outlook justifies imminent monetary policy loosening. However, most of the BoE speakers we have heard since last meeting’s dovish pause have been concerned about the sticky elements of inflation.
While the BoE should cut this week, whether they will is highly uncertain. One driver could be their forecasts. Although they will not want to lean too much on the medium-term forecasts (as per Pill’s speech), we see downside risk to their near-term CPI forecast (Chart 1). In particular, we do not see the same degree of July bounce-back as they do.
If they were to revise their near-term forecasts closer to our assumption, then a cut now would be easy to justify. Regardless, our base-case remains that the market is too hawkishly pricing the BoE more generally, and that if they do not cut this week they will simply need to do more later.
We still like to be short Z4 SOFR vs long Z4 Sonia given market pricing still appears overly dovish in the US (100bp over next 12 months for the BoE, versus 140bp for the Fed), and being long 10Y UK bonds targeting 3.5%.
Putting the ‘Fun’ in Fundamentals
Fundamentally, we think the BoE should have started easing earlier in the year. However, the BoE appears recently to be driven more by concerns that they will appear to be calling victory prematurely. This is why we expected that they would choose to telegraph clearly why (if) they cut this week. The lack of that messaging adds to the uncertainty, but at the same time, historically the BoE has not been averse to surprising the market.
Dovish Rationales
- UK policy transmission has been fast and strong, particularly in comparison to the US and EZ and aggregate demand looks weaker.
- Sluggish retail sales add to the idea that consumer-facing firms’ capacity to raise prices is limited.
- Recent volatility in services inflation appears to belie a relatively normal trend in the wage-intensive sectors. Meanwhile, headline and core are in line with MPR (Chart 2). A drop back in July hotel prices could open the BoE to undershooting target.
- Private-sector regular pay growth is now running in line with MPR forecasts, unemployment (if you believe the data) is meanwhile overshooting (Chart 3). This is important, as at the last meeting they noted concern on pay overshooting.
- The Chancellor is gearing up for spending cuts and tax rises to cover newly discovered holes in the public finances, this will further suppress aggregate demand. Note: strong public wage rises (if she delivers) would support AD, but would not be a cost pressure. The BoE is focused on private regular pay.
Hawkish Rationales
- Services inflation continues to strongly overshoot MPR forecasts (Chart 4).
- There has been little by way of comments from the internal members of the MPC. This is important as if (our long-standing expectation in line with previous BoE comments) they seek to make their first cut a hawkish one, strong telegraphing will make their job much easier.
‘Not Cutting Back to Zero’
The tone of comments is likely to concentrate (whether they cut or not), on the fact that a reduction in bank rate from 5.25% does not mean policy is easy, just less tight than otherwise. The gist will probably be that conditions continued to tighten even while bank rate has remained flat. More specifically: real rates have risen and policy tightening will continue while low rate mortgages are refinanced at higher rates (Chart 5).
The hawkish-skew in commentary is justified by the fact that the UK policy transmission to mortgage holders is concentrated in the 3-5Y swap space. A pushback on back-to-back cuts would not be surprising – or at least a remark that this is not a foregone conclusion. At the same time, if the data undershoots BoE expectations, then they could well deliver more this year than the market is pricing.
Could QT Slow Ahead?
The BoE began reducing its APF holdings via £100bn pa in November 2023, after having agreed that sum at their September 2023 meeting. This has involved active sales of around £12bn (nominal) per quarter.
This is a relatively heavy rate by international standards, and has been very costly to the Treasury (who have to fund APF losses); expected to amount to around £100bn over the lifetime of the APF. This is in effect a transfer from the previous government (which made gains on the APF purchases) to the current one.
While it is not our base-case to expect a wind-down in QT imminently, it seems likely (given the fiscal situation), that the government will put increasing pressure on the BoE to slow active sales. If that is the direction of travel at the September/November meetings, then we may hear some comments laying the ground for this now.
.
(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.)