BoE Preview: Reaction to Budget Is a Big Unknown

Summary

• We expect the BoE will cut rates by 25bp this week, with a 6:3 vote split.
• The accompanying MPR will be important, there are many moving parts, particularly the inclusion of the UK’s new budget.
• My expectation is that BoE look through much of the budget impact, retain expectations for further gradual easing, and are cautiously optimistic that the likelihood is falling for their most hawkish scenario from August.
• We have previously noted that much of the OBR’s deficit estimates were driven by assumptions on the BoE’s reaction function. If they do look through much of the budget impact, then it opens the path to being more bullish UK rates again.

Market Implications

• If the BoE forecasts and tone comes out as we expect, we would see value:
  • Entering short-end receivers;
  • Positioning for gilt curve steepening.
• We retain our 10Y GBP receiver vs 10Y EUR payer but would close if the BoE reaction function comes out more hawkish.

25bp Cut. Room for Dovishness, but Caution More Likely

BoE Reaction Function to Budget Key for UK Rates

We expect the BoE to cut rates by another 25bp (to 4.75%) at this week’s meeting with a vote of 6-3 (Greene, Mann, Pill dissenting). They will also provide updated forecasts for their MPR, which will need to include a number of conflicting themes:

1. Recent data has tended to undershoot forecasts – DOVISH.
2. The new budget is probably inflationary early in the horizon, but negative for real disposable income and consumption. Effect further out unknown – HAWKISH.
3. The market is pricing more cuts than pre-August MPR.

My base case (as set out in Table 1) is that the BoE looks through much of the budget impact, noting that hotter growth near-term will not affect the policy path and the effect further out is too uncertain to conclude either way.

I expect they will need to revise near-term forecasts more dovish overall, and despite raising long-end horizon inflation (due to lower market rates), they can probably reduce the positive skew to the outlook (keeping mean and median plots capped).

If this turns out to be the case, we would see value in receiving short-end GBP (for at least four cuts over the next 12 months), and positioning for gilts 2s10s steepening.

Forecasts Have a Lot of Moving Parts

Assessing the changes in data and in forecasts must take into account that the MPR set out its August forecasts as a weighted probability of three “cases” (scenarios):

1. Dovish: Wage price rise shocks seen in the last few years are transitory and inflation normalises with less restrictive monetary policy
2. Neutral: A period of economic slack (output gap, rising unemployment) is required to normalise wage and price setting dynamics.
3. Hawkish: The economy has seen a structural shift following the shocks, monetary policy will need to be tighter for longer.

As such, the forecasts in August were relatively dovish, but had positive skews for growth and inflation reflecting upside tail-risk from “Scenario 3”. Chief Economist Pill and external hawk Greene have explicitly cited concerns around “Scenario 3” as justifying their hawkishness.

Services Inflation and Wage Growth Look Less Concerning

The probability of the scenario seems to have reduced since the August MPR. Private regular wage growth and services inflation have greatly undershot BoE expectations (Charts 1 & 2).

Meanwhile, the budget is expected (by the OBR) to drive lower pay growth ahead (Employer NIC rise) and reduced consumption spend (on crowding out), further reducing likelihood of “Scenario 3”.

However, the MPC will also have to balance the risk that the Employer NIC rise causes cost pressures passed onto consumers. That firm surveys seem sanguine on aggregate demand reduces the risk of this.

Labour Market and Growth Outlooks May be More Bullish

On one hand, the LFS unemployment rate has undershot MPR, but at the same time claimant count rate has risen much higher (Chart 3). LFS is less credible data, suggests that if they do revise down their unemployment rate, they will caveat that the labour market may be looser than it suggests. I expect they will take comfort from the lower wage growth and lower vacancies that the labour market is loosening.

GDP’s level has meanwhile been revised above expectation on the back of the Blue Book revisions, but growth in Q2 and (likely) Q3 has undershot BoE forecasts (Chart 4).

I expect that the path of unemployment and growth will be revised more bullish into the middle and end of the horizon on the budget impact and lower market rates.

Watch Comments Closely

Regardless of the numbers of the forecasts, the market should focus more on the tone of accompanying comments. There is space for the BoE to tack hawkish or dovish on this front with regards to the budget.

A hawkish outcome would be a softening of the comments around gradual loosening ahead, and indications that the budget has lowered the likelihood of the most dovish scenario. This would open the way to a slower reduction in bank rate (at least until the data/events require otherwise).

Our base case is that the budget has not greatly affected the MPC’s expectations for the near-term policy path (gradual loosening retained), and that the implications further out are too uncertain. I think there is scope for them to accept that the risks of Scenario 3 have reduced since August.

Very dovish comments would be that the budget has reduced inflation at the end or else just beyond the end of the forecasting horizon and that the probability of a “Scenario 3” has materially reduced.

I expect they will err away from too dovish comments at this stage given the large uncertainty of disinflationary effects from the spend, and the high degree of uncertainty from other contemporaneous events (US election, Middle East tensions). As such, a meeting-by-meeting approach seems most appropriate.

Bias Remains That Market Is Underpricing Cuts

On the back of the above, our bias remains that the market is underpricing the extent of bank rate cuts possible over the next 12 months (just three cuts fully priced).

If the BoE comes out as we expect, this will open the path for relative outperformance in UK rates and for front-end led steepening. This is because the OBR’s expectations for deficit have been greatly driven by the assumption that the BoE will react strongly hawkishly to the budget, if this is not the case then Bank Rate can be cut more sharply and the deficit can undershoot.

As we have repeatedly noted, there is little risk-reward in attempting to pre-empt the move. If the BoE does come out as we expect, we would enter short-end receivers, retain our 10Y GBP receiver vs 10Y EUR payer, and position for gilt curve steepening.

(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.)