BoE Preview: A Strong Tightening Before the Pivot?

Summary

• The Bank of England meets on 3 November to set its policy rate. We see a high likelihood of another 75bp hike to quash the medium-term effect of the recent consumer support, with a tail risk of 100bp.
• However, the BoE will 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 should remain strongly dovish, with a deep downturn in GDP, and a continued undershoot in medium-term inflation.

Market Implications

• There should be value positioning for a lower BoE terminal rate.

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 disagree for the ECB and Fed). Yet we have been arguing that the BoE will need to pivot dovish for some time.

Nevertheless, the market remains stubbornly committed to the belief that the UK terminal rate will exceed that of the US and Europe (Chart 1). This is even though the BoE has been hiking far longer (two months more than the Fed, and eight months more than the ECB).

Monetary headwinds are therefore likely to hit far sooner in the UK. Meanwhile, 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 Monetary Policy Committee (MPC) has been reluctant to accelerate hiking. And it refused to support GBP after the fiscal event (as many commentators wanted them to).

Now, the three pillars that justify hawkish action (fiscal stimulus, inflation expectations, and a 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 Ben Broadbent put it, 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 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 while also providing the frontloading that the hawks favour.

The hawkish market pricing is important. The UK’s mortgage market means the short-end of the GBP curve has a significant influence on consumer credit cost. 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 like our forecast (Chart 4). Further out, it is likely to undershoot target by a greater margin given the market pricing for interest rates and the BoE’s recession expectation. The uncertainty is 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 Have Commenced

The BoE’s current path to selling its gilt holdings 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 no longer clashes with beginning of active sales).

£10bn sales per quarter will likely remain the aim. Yet we expect the BoE will be pragmatic on the back of market conditions, and the risk of this is to the downside. The first gilt sale auction (1 November) went without a hitch. 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).

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.)