BoE Preview: Pressing Pause

Summary

• We see a high likelihood that the Bank of England (BoE) hikes again. The weight of probabilities favours 50bp (to 4.0%), but there remains a strong tail risk for a deceleration to 25bp (to 3.75%).
• Updated forecasts will provide the key. For inflation, they will need to be tempered downwards in the near-term, and likely show continue to significantly undershoot target in at the end of the horizon. Such an outturn should justify a pause.
• There is a risk that strong recent wage and employment growth may prevent Governor Bailey sounding too dovish, but this shift should come before March.

Market Implications

• There remains value positioning for a lower BoE terminal rate and a steepening in 2s10s gilts.
• Along with our expectations for European Central Bank (ECB) hawkishness, expect higher EUR short-end swap rates vs GBP, which should drive EUR/GBP higher.

50bp Hike Likely, 25bp Possible

The MPC has been relatively quiet since the BoE’s last meeting in December. Comments from Governor Bailey since then have been relatively subdued; he has been careful not to explicitly condone or reject current market pricing. Where he will land at the upcoming meeting will likely be driven by the updated monetary policy report.

There, three conclusions are likely:

1. Near-term inflation expectations will need to be revised lower on recent undershoots, lower energy prices and the more generous Energy Price Guarantee announced at the Autumn Budget (Chart 1).
2. Near-term GDP profile will need to be revised higher on recent outperformance and fiscal uplift (Chart 2).
3. Unemployment profile will need to be revised higher on labour market slowing (Chart 3).

The most important aspect will be the medium-term inflation outlook. Comparing with the ‘no change to interest rate’ profile from November, the weaker labour market, higher current rates, lower near-term inflation and additional medium term fiscal tightening should keep the end of the profile strongly below 2%. A Q4 2025 estimate around or even below 1% would not be a surprise in my view. With such an outcome, it will be hard for Bailey not to push back on the terminal rate.

An important aspect of the inflation outlook will remain the inflation expectations. It is hard to argue that expectations are significantly de-anchored from typical levels (Chart 4). DMP price setting expectations are still significantly above average, but the rate is coming down quickly as inflation drops. While this remains the case (and the BoE expects a rapid decline in inflation from Spring), the above average current reading will not be an issue.

Mortgages, Too, Provide Strong Reasons to Tack Dovish

December saw the lowest rate of new mortgages since 2008. This, along with a collapse in survey estimates of housing market health suggest a significant decline in house prices lies ahead (Chart 5). Households remain under a great deal of pressure, and the rise in mortgage rates will continue to feed into this. This effect is unlikely to diminish ahead, unless the BoE takes action. Swap rates have declined from their peak in October, but mortgage rates remain incredibly high versus recent history, and the longer they stay elevated the more deleterious their impact will be (Chart 6).

On the back of the likely more dovish forecasts, and the growing pressures on households, there remains a strong incentive for the MPC to push back on market pricing by going for a smaller hike (25bp), and/or guiding that the BoE may pause hiking after this meeting. There should therefore be value in fading the terminal rate currently priced, and being long short-end gilts versus the long-end (we like 2s10s steepening).

Base Case Terminal Rate: 4% With Downside Risk

There seems to be good rationale for the BoE to shift to 25bp, but the strong recent outturns for employment and wage growth (the latter of which continues to accelerate) make it difficult right now. On this basis, while there is a tail risk for a 25bp hike, my base case remains for 50bp, and a pause (terminal rate 4%). The risk to this outturn would be if Bailey refuses to explicitly back a pause at this stage – however, as new data emerges, and the labour market continues to deteriorate, I would expect they will settle there before March.

Dovish BoE < Hawkish ECB Means Higher EUR/GBP

The BoE meeting will coincide with the ECB, with likely some overlap of Bailey’s press conference with the ECB rate decision. At the ECB, we expect a hawkish tone to persist through the comments and the presser. If my expectations prove accurate, there is probably room for at least another 40bp of increase possible in 2Y EUR – GBP swaps. In turn, this should allow for a move back towards 0.89 in EUR/GBP with upside possible (Chart 8).

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.

(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.)