BoE Preview: A Strong Tightening Before the Pivot

Summary

• We see a high likelihood that the MPC votes to hike the policy rate by 75bp to quash the medium-term effect of the recent consumer support, with a tail risk of 100bp.
• The BoE will however guide to a far lower terminal rate than the market is currently pricing. This pivot could come as soon as this meeting, or at the latest in February.
• BoE forecasts to remain strongly dovish, with a deep downturn in GDP, and a continued undershoot in medium-term inflation.

Market Implications

• On the back of a likely undershoot of terminal bank rate vs. market expectations, we see value in receiving Q1-expiring GBP swaps.
• The more dovish BoE, alongside a lower requirement for DMO issuance (after the 17 November fiscal plan) should leave room for gilt curve steepening.

The Market is Overpricing BoE Hikes

Central banks have begun to turn dovish. Or at least that is what market pricing would have you believe (we don’t yet think it’s the case for the ECB, or the Fed). Yet, we have been arguing that the BoE will need to pivot dovish for some time. Nevertheless, while some of the extreme (+6%) expectations for the terminal rate for the BoE post-fiscal event has been priced out, the market remains stubbornly committed to the belief that the UK terminal rate will be above that of the US and Europe (Chart 1). This is despite the fact that the BoE has been hiking far longer (2 months more than the Fed, 8 months more than the ECB). Monetary headwinds are therefore likely to hit far sooner in the UK. At the same time, the UK economy is already lagging others in its post-pandemic recovery (Chart 2).

More Now, Less Later

In line with our expectations, and despite market pricing, the MPC has been reluctant to accelerate hiking and refused to dive in to support GBP post-fiscal event (as many commentators wanted them to).

Now, the three pillars that justify hawkish action (fiscal stimulus, inflation expectations, and tight labour market) are beginning to fade. It was the fiscal event that drove the neutral voices to look for acceleration, and for good reason. As Deputy Governor Broadbent put it (more eloquently, admittedly), they did not know how to respond to the terms-of-trade/energy shock but responding to aggregate demand driven by fiscal stimulus is their bread-and-butter. As such, we see the BoE hiking 75bp to 3% (with a tail risk of 100bp) to immediately quash the medium-term inflation effect of fiscal policy.

Such an aggressive hike would likely drive market pricing upwards, and mortgage rates with them. Therefore, we expect for the MPC to adopt a more dovish outlook, supported by forecasts that continue to point to recession and an undershoot in medium-term inflation. In other words, they will hike strongly now, but push back against terminal pricing. This should be enough to sate the doves, including Dhingra (who voted for 25bp at the last meeting), while also providing the front-loading that the hawks favour.

The hawkish market pricing is important. Given the UK’s mortgage market, the short-end of the GBP curve has a significant influence on consumer credit cost (see here for our analysis on the mortgage rates). Even with the recent paring of mortgage rates and the energy price guarantee, households remain under enormous pressure (Chart 3).

BoE Forecasts – Paring CPI and GDP

The updated monetary policy report (MPR) will need to reflect the significant paring of near-term inflation on the back of the energy price guarantee (EPG), as well as restrictive pricing for bank rate. We expect the near-term profile will look not dissimilar from our own forecast (Chart 4). While further out, it is likely to undershoot 2% by a greater margin given the market pricing for interest rates and the BoE assumption of recession. The uncertainty is around how the BoE will treat utility prices after April (when the EPG will be revisited).

Importantly, from the recent readings, the monthly profile (unlike in Europe) appears to be continuing to normalise (October’s jump is on the energy price cap rise). That should provide comfort that the worst is behind them.

Active Gilt Sales to Commence This Week

The current path to active gilt sales looks likely to remain. The paring of unfunded spending from the ‘fiscal event’ helps the case significantly. As does the delaying of the Chancellor’s medium term fiscal plan into the middle of November (meaning it will no longer clash with beginning of active sales).

While £10bn sales per quarter will likely remain the aim, we expect the BoE will be pragmatic on the back of market conditions, and the risk this is to the downside. With the first gilt sale auction scheduled for 1 November (short), it will be important to watch imminent market reaction to the situation. Further out, we expect the DMO issuance plan will likely be revised lower after the medium-term fiscal plan (17 November). This will probably see <7Y issuance pared back most (Chart 5).

Trade Idea: Fade Short-End Weakness

On the back of the commencement of short bucket gilt sales this week, and the BoE’s need to deal quickly with the EPG’s medium-term consumer support, there is some uncertainty around very short-end rates right now. The safest way to play it at this stage is to receive Q1 2023-expiring GBP swaps (where our expectation versus market pricing diverges most; Chart 6). Meanwhile, on the likely lower DMO issuance requirement, fading short-end weakness and positioning for curve steepening (2s10s or 5s10s) also looks attractive, which our PCA analysis agrees with.

The risk to the view would be a significantly more hawkish outlook from the MPC, in which instance we would reconsider our view.

Appendix: Surveys & Data

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.)