BoE Preview: 50bp, Heavy QT and a Dovish Outlook

Summary

• Given recent comments, the chance is high that the MPC decides to hike bank rate by 50bps to 1.75% on 4 August. However, we do not completely discount the possibility of a smaller 25bp, and expect the tone around more hikes will be decidedly dovish.
• More information on the path for active gilt sales is expected. While Bailey may not provide guidance around explicit quantities yet, we expect they will ultimately come to lean on QT more than hiking to tighten policy.
• The updated MPR will likely show a weaker growth outlook, and a further rise in peak CPI on the back of Ofgem price cap rises.
• Into the end of the forecast horizon, the ‘market price-based’ inflation forecast is likely to significantly undershoot target, while the ‘flat bank rate’ forecast will probably not be too far from 2%.

Market Implications

• We continue to see value in receiving November settling GBP forward OIS swaps, and will re-visit the trade post-BoE.
• We continue to see value in positioning for relative gilt steepening vs EGBs, which is a structural play on relative ECB/BoE policy path.

50bp Now, But Under-delivery Later

50bp is on the table for the 4 August BoE MPC meeting. That is the clear tone from MPC policy makers’ recent comments. Given the current inflation climate, and the need to get to neutral rate, right now this looks like a credible possibility (Chart 1). However, beyond that, we remain of the view that the market will be disappointed by the ultimate policy path.

The rationale for this has not changed since we first set this out as our base-case. In fact, it has grown stronger:

• This will be arch-hawk Michael Saunders’ last MPC meeting. Even his recent wording around future policy rate seems relatively tame: he does not regard hiking to 2% (the middle of his neutral range) or higher over the next year as implausible or unlikely (Chart 2).
• Business and consumer surveys continue to deteriorate (Chart A4 in appendix). This will only get worse as households are about to get crushed by enormous energy price rises in October (Chart 6).
• Active QT is set to begin in September. The BoE should be cautious in pulling too many levers at once. Our long-held view is for them to prioritise households over the market and lean more on QT than hikes. Bailey’s recent bands for active sales (somewhere between £1.3-5.5bn/m) leaves good room for this (Chart 3). That financial conditions have eased recently will help the case for more (Chart 4).

Why Might the Market Price in More Hawkishness?

There are several reasons why the BoE may shift more hawkish. But right now none of them are strong enough to dissuade me from my view. Some examples are:

• Near-term inflation within the MPR will likely be revised significantly higher. The Ofgem energy price cap rise for October (tba early August) will need to rise a lot more than was previously assumed (Chart 6). However, this is not actually a hawkish outcome. A 50% (or more) rise in energy bills is completely beyond the scope of the BoE. And it would be unlikely to raise the medium-term inflation outlook. It will put even greater strain on households and incentivise a further shift away from real consumption (Chart A5 in appendix).
• Why would the BoE move in a record clip (50bp) if they’re just going to pause straight after? The arguments from the hawks in the BoE have pretty consistently been that more now means less later. Front(ish)-loading hikes in that context is not entirely unreasonable. The ECB only last week said that their ultimate target is unchanged by the change in pace. Meanwhile, an opportunity to pause to assess the effect of the larger move when they are about to enter active QT would also make sense.

The MPR: Near-term Inflation Spike, Medium-Term Undershoot

The meeting will see the updating of the MPR, and with it the BoE’s forecasts for major economic data. It will be important to see the expected effect of announced UK Government household support measures. The inflation forecast will likely be of most interest (unemployment will still be forecast to remain low, while economic output will likely be revised down somewhat).

A Q4 peak CPI assumption will likely remain unchanged (Chart 5). Since May, BoE speakers have warned that the peak level would need to be revised higher, but the scale of that rise could be even greater than they had realised then. Ofgem’s CEO guided that a 42% rise in the energy price cap would be needed in October based on price data seen in late May. Since then, the price has more than doubled (Chart 6).

The offset may come from an energy VAT or fuel duty cut by the new PM, but this is unlikely to be included into BoE expectations until it becomes policy. In the meantime, the price spike will further crush consumer sentiment, and with-it, economic growth.

Further out, the medium-term headline inflation forecast (predicated on market pricing for rates) is likely to undershoot the target even more than previously. In May, Q2 25 CPI was forecast at 1.45% based on bank rate peaking at 2.6%, while with a flat 1% bank rate, CPI ended at 2.32%. Now, the forecasts will need to account for growing headwinds to underlying demand, and higher assumed rates. For the market-based forecast this will amount to 40bp of additional tightening, while the ‘unchanged-rates’ forecast will need to account for up to 50-75bp. The risk is consequently high for the inflation forecasts to soon point towards no more hikes being needed.

Fade BoE Hawkishness & Position for Gilt Steepness vs EGBs

We expect the BoE will temper expectations for further rate hikes at the meeting, which should feed further into our view that there is value in receiving November settling GBP forward OIS swaps. Since we wrote on the trade, it has moved 25bp in our favour, about half the distance we ultimately expected. We will revisit the idea after the meeting.

Meanwhile, with the push into QT imminent, we continue to see value in positioning for relative gilt steepening vs EGBs. Since we wrote on the subject, the trade has moved 10bp in our favour. We expect that this has significantly further yet to go.

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.)