BoE Monitor: Turning the Wage on Hawkishness

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Summary

• The BoE hike by 25bp to 5.25% as we expected. And while we had seen a big risk of a 50bp hike, there were two votes for such, the majority of the MPC are clearly more reactive to near-term inflation misses/beats.
• As expected, the content of the MPR forecasts was more dovish. There is continued room for more dovish surprises ahead.
• Wage growth remains too high, but the BoE should be able to overlook strength there on inflation and labour market weakness. We see wage tailwinds turning to headwinds on employment composition.
• The BoE’s arbitrary construction of wage forecasts could mean any downside surprise there sees a rapid reassessment of their outlook.

Market Implications

• Despite Bailey’s indication that bank rate can stay high for a long time, we see continued value in positioning for relative BoE dovishness (vs ECB and Fed) and for 2024 cuts. This is best expressed via 2s10s GBP steepening vs EUR and by being short 1Yx1Y US OIS vs 1Yx1Y SONIA.
• Our expectations for weaker data ahead justify value in being short the 10Y UK inflation swap. However, if the BoE does indeed end up reacting stronger to the detail rather than the headline, headline beats could lead us to reassess the trade.

Current BoE Forecasts

Link to Most Recent BoE Meeting Minutes

Dovishness in the Forecasts

The Bank of England (BoE)’s Monetary Policy Committee (MPC) voted to raise bank rate by 25bp to 5.25% at its meeting on 3 August, in line with our expectations. We had seen a moderate risk of a 50bp hike, but the recent bearish data outturns had been enough to dissuade them. In the end, the 25bp hike was supported by six MPC members, while two members (Haskel and Mann) voted for a 50bp hike and one (Dhingra) voted for no change.

As expected, the details of the August Monetary Policy Report (MPR) were more dovish than in May (see table above and Charts 1-3 below):

• CPI was lowered across the rest of 2023 and 2024 but revised slightly closer to target in 2025 (Chart 1).
• The path for unemployment received a parallel shift higher (now to 4.8% in Q4 2025), retaining its very shallow near-term trajectory, which could mean it becomes stale soon.
• Meanwhile, the GDP forecast was increased in 2023 but reduced across 2024 and 2025 leaving a net slightly lower trajectory. Data this week is expected to undershoot their projection.

And while the BoE is forecasting c.6% for private regular pay growth, at Bailey’s own admission, this sits decently above model estimates (reflecting a skew designed to counter consistent under-estimates, Chart 4). The mystery of wage growth’s recent overshoot is really one of why employment composition is still supportive, and how long this anomaly will last (more on that below).

The BoE’s median models based on market-based and flat 5.25% bank rates follow similar trajectories, in line with the MPC’s insistence that many different paths would lead them to 2% in medium-term inflation.

Room for Labour Market Dovishness

The labour market is critical to the BoE’s forecasts. The BoE retains a very shallow rise in unemployment rate; just a 0.1ppt rise to end-2023. In our view, there are two strong upside risks to this:

• Recent momentum and surveys suggest employment decline will continue ahead.
• We expect the participation rate to stay stable or rise on the back of depleted savings. For context, a rise back to pre-2020 highs would push unemployment to almost 5% (holding employment constant).

The MPC has eschewed its poor performing wage models by adding a wedge on top of their outputs, taking the YE forecast to 6%. Such an outturn would require a halving of current MoM wage growth to the year-end, a far more significant slowdown is possible.

The contribution to wage growth from employment composition is currently highly positive. However, in the past it has tended to revert to correlate with relative full-time and part-time job growth (as happened in late 2010 and 2014). If this occurs again, the change in employment composition already seen could carve off c.0.6ppt from YoY wage growth (Chart 5).

An important implication of them fudging their model output to raise estimates is that if wage growth corrects sharply lower ahead (as inflation did), there will be little to prevent the MPC from dropping their estimates as quickly and with it shifting their outlook much more dovish.

MPC Appreciating the Data Nuances

While many of the aggregate UK inflation measures (including headline, core and services) remain strong, the detail is much less so. Idiosyncratic rises and policy tightening pass-through have elevated aggregate readings (Chart 6). The MPC seemed more receptive to this notion at the presser, noting they are overlooking surprises in services driven by volatile components.

Additionally, their recent publications on inflation swaps, and rental pressures suggest they may also choose not to reading too much into continued elevation in inflation swap levels or the high current (or future) rental inflation. Weighting their assessment of medium-term inflation expectations towards surveys should provide them some comfort (Chart 7).

Trade Implications

We continue to see value in positioning for relative BoE dovishness versus other central banks. In particular, vs the ECB via a 2s10s GBP/EUR box (target: -10bps) and vs the Fed via short 1Yx1Y US OIS vs 1Yx1Y SONIA, which we have extended our target for from -100bp to -50bp. The risk to these trades from the UK side, is that if the market moves too far, and the BoE take it as an easing in the all-important 2-5Y space, we could get some pushback from the MPC in the near-term.

We still like to be short 10Y UK inflation swaps (target: 3.65%) on the expected re-anchoring of inflation pricing towards more normal levels. There are two newly emerged risks to this trade:.

• LDI/PFs are generally the largest receivers of inflation swaps and hence flows there could keep the rate elevated.
•  A more dovish reaction to even strong headline numbers could be seen ahead if the BoE is truly focused on the details. This might lead the market to price more into longer-term inflation if we get strong headlines with weak details.

We will re-assess the view if either of these factors seems to be weighing heavily against us.

DMP Survey Overall Dovish

The latest Decision Maker Panel survey (DMP) had some mixed results, but overall set a more dovish tone. The dovishness came three-fold:

• Net hiring difficulties eased again while expected employment growth dropped to 1.2% from 1.9%, suggesting a loosening in labour market conditions (Chart 8).
• 3Y CPI expectations dropped further to +3.3% while 1Y expectations fell to +5.4% (Chart 9).
• 1Y ahead wage growth expectations dropped to +5.0% from +5.3% (Chart 4).

However, 1Y ahead price setting (which spiked to 5.6% from 4.9% previously) provided a hawkish detail. This is perhaps the most important outturn for the DMP (given they are the price setters). It suggests the re-anchoring in expectations will not be smooth sailing, but the trend remains favourable (Chart 9).

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.)