Monetary Policy & Inflation | UK
The Bank of England’s Monetary Policy Committee (MPC) appears to have delivered a key message: rates will have to rise. Yet UK interest rate markets are pricing a 20% chance of a 25bp rate cut by January 2020, and an over 40% chance by early 2021. The difference appears to come down to a more optimistic Brexit and global growth view from the BoE than investors. If the Bank sticks with this view, and it’s a big ‘if’, then it may need some nifty footwork to guide markets in the right direction. This week’s MPC meeting on June 20th will be their chance to demonstrate their skill…
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The Bank of England’s Monetary Policy Committee (MPC) appears to have delivered a key message: rates will have to rise. Yet UK interest rate markets are pricing a 20% chance of a 25bp rate cut by January 2020, and an over 40% chance by early 2021. The difference appears to come down to a more optimistic Brexit and global growth view from the BoE than investors. If the Bank sticks with this view, and it’s a big ‘if’, then it may need some nifty footwork to guide markets in the right direction. This week’s MPC meeting on June 20th will be their chance to demonstrate their skill.
The Return of England’s Nemesis.
The BoE may end up adopting the Maradona theory of interest rates. Back in 2005, its governor, Mervyn King, invoked the footballer’s second goal against England in the 1986 World Cup as a strategy the Bank could adopt. In that match, Maradona beat five defenders by simply running straight. The English players were reacting to what they thought he’d do, rather than what he actually did. King argued that ‘monetary policy works in a similar way’, and so even if the Bank were to do nothing, it could make the market believe it will hike and, in this way, could still reach its goal.
Faulty Brexit Optimism
But getting markets onside may be difficult. MPC member Michael Saunders recently presented an optimistic post-Brexit path for the UK by citing a catch up in UK investment spending. It has significantly lagged behind the rest of the G7 since the Brexit vote on 23 June 2016 (Chart 1). Financial markets, notably the pound, aren’t so positive, however, not least because of the uncertainty around the range of policy outlooks under either a deal or a no deal scenario. And a new Conservative leader and, consequently, a new Prime Minister due to be elected by late July increases the risks of a no deal Brexit given the high probability that whoever takes on the role will sit firmly in the Brexit camp.
Global Growth Pessimism
On top of Brexit, the global growth outlook has deteriorated. The MPC, however, does not seem to recognise this. Saunders’ latest speech (10 June) in fact suggests that the BoE is anticipating a recovery in global demand. But the Fed’s acknowledgment that the next move in rates could be downwards, coupled with far more dovish tones from the ECB, means the market takes the opposite view. That is, that cuts are coming. It is fair to point out, as Saunders has, that the BoE is at a different point in the cycle, and, with the output gap closed, needs to get rates higher. Yet markets will struggle to see the BoE hiking rates in an environment where the US is cutting.
MPC can’t Hike
Of course the MPC could well acknowledge these gathering storm clouds at their meeting on 20 June, but with policy still regarded as loose, the MPC will likely seek to retain a medium-term tightening bias. The reality is that UK rates are stuck. And potentially for quite some time. A vote to raise rates in the face of the twin risks of Brexit and a deteriorating global backdrop looks unlikely, while already loose policy ensures an easing will not occur unless there is a Brexit catastrophe.
Not a Broad Rise, but a Steepening
So the MPC trying to talk policy tighter could be in the hope of the market following their words as opposed to their probable actions, much like the Maradona principle. Unfortunately for them, the market is not playing ball with the BoE’s SONIA forward swaps curve, pricing next to nothing by way of policy tightening over the coming five years (Chart 2). It remains logical to price some risks of a near-term cut given the uncertainty surrounding Brexit. No deal would surely see the front end pricing Bank Rate in the 0-25bp range. Conversely, if the global risk picture improves, we can expect longer tenors to underperform. The most likely result of BoE talk, then, would be a steepening of the curve, rather than an increase in rates across every tenor.
Chart 1: UK and G7 (ex UK) – Real Business Investment
Indexed to Q1 2007 = 100
Source: Michael Saunders/Bank Of England
Chart 2: Very Little Tightening Priced Into Forwards
Source: Bank of England
Jason has been a sell-side rates strategist for over 20 years. During his career, he has predominantly focused on the UK, but he also looks at markets from a global perspective.
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