BoE Preview: Case Builds for Steepening, But It May Not Come Just Yet

Summary

• We expect the MPC will vote for a 25bp hike in bank rate to 1%. There is a risk that this will not be unanimous, with a possibility for dissention in both directions.
• The BoE will likely provide new information on active gilt sales. The market is now expecting relatively little at this meeting, so the risk is skewed towards a more hawkish outcome.
• Economic forecasts are likely to be more downbeat for GDP, with a strong focus on the pressure on consumer spending.
• Labour market tightness and wage growth will remain concerns that continue to support the need for monetary tightening.
• CPI forecasts for the rest of 2022 will see a strong upward revision. However, further out the horizon, the fan charts should see a fall further below their 2% target.

Market Implications

• The longer-term inflation outlook will point towards a lower terminal rate than is currently being priced.
• The rise in near-term inflation forecasts and concession on the previously assumed temporariness of inflation may allow the market to ignore this messaging for now.
• Further out, the attractiveness of QT over rate hikes in an environment of consumer weakness will support bear-steepening moves ahead.
• We see 2s30s gilt steepeners as an efficient way to play this.

A Difficult Balancing Act

The BoE will need to walk a careful line on messaging at Thursday’s meeting. There is majority agreement on the need for further tightening within the MPC, and the strong likelihood is for a 25bp rise, but the probability of dissenting votes is high, and the messaging will need to be strongly nuanced.

There has been a recent spate of hawkish central bank surprises (RBA, and Riksbank for instance), which have come amidst an increased appetite for larger increment hikes. BoE hawk Catherine Mann is perhaps the mostly likely to vote for 50bps, given her belief that a faster tightening may mean less tightening overall. On the other side, there is a chance that dove Jon Cunliffe, and perhaps Silvana Tenreyro, vote for no change.

The difficulty is that even the hawks are starting to worry about the pressures on the UK consumer. Over-heated domestic demand (what monetary policy is designed to deal with) is not the issue right now, and the squeezing of real incomes and the tight fiscal environment will ensure that this remains the case going forward.

Immediate Gilt Sales Not Expected, But the Risk Is to the Hawkish Side

The BoE has previously guided that a 1% bank rate is a necessary but not sufficient requirement for the beginning of active gilt sales. The elevated financial market uncertainty that the Russian invasion of Ukraine has brought has necessitated further guidance emphasising this fact. Thursday’s meeting is instead likely to see additional details on how active sales might play out in the future. With the market expecting little in the near term, the risks on this front are tilted towards a more hawkish path for QT than is currently priced in.

There are several reasons for this belief:

• It is widely accepted that the MPC has shifted more hawkish recently. The labour markets continue to look tight, and timely data shows that wage rises remain substantially above pre-pandemic levels (Chart 1).

• Bailey has conceded the likelihood that inflation will be less transitory than previously assumed. The BoE’s new inflation forecasts will reflect this (Chart 2).

• With consumers under pressure from rising rates, fiscal tightness, and rising energy prices, the attractiveness of tightening via the bank rate is diminished.

• This leaves quantitative tightening as relatively more palatable.

• Even while financial conditions have been hit by the war, financial institutions remain resilient. Credit spreads have widened, but they remain within the mid-to-lower end of historic ranges (Chart 3).

In short, the BoE will prioritise UK consumers over market participants in its path for tightening. This suggests that, despite near-term market worries, the BoE should be gearing up to lean more heavily on QT than on the bank rate.

MPR Forecasts – A Spike in 2022 CPI, But a Decline in 2024

Back in February we stressed the fact that the MPR showed CPI undershooting its target of 2% towards the end of its forecast horizon (as per Chart 1). At the time this was a sign that market pricing for bank rate (on which the forecasts are conditional) had gone too far. Since then, an additional 50bps have been priced into the bank rate for December 2022.

It is likely, therefore, that even with more persistent inflation pressures through 2022, the end-of-horizon forecast will show an even greater undershoot of inflation in the updated MPR forecasts. We would take this as further indication that the BoE will push back against the market’s pricing of bank rate.

Will This Be the Point to Trigger Bear Steepening?

The risk, as we saw in March, is that the market will continue to ignore the more dovish messaging. Amid the likelihood of headline-grabbing increases in near-term inflation forecasts, and the possibility of hawkish dissent in the vote, the risk is that market continues to do so.

The case, nevertheless, remains strong for bear steepening in the gilts curve (Chart 4). We continue to see an efficient way of playing this as being via 2s30s steepeners, which should benefit from the eventual temperance of hike pricing, the year’s net-supply picture, and the structural change in long end demand from pension funds.

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.)