BoE Preview: 50bp Hike and Active Gilt Sales, but the Dovish Case is Growing

Summary

• We see a high likelihood that the MPC decides to hike bank rate by 50bps to 2.25% on 22 September, supported by recent comments that point more to a ‘wait and see’ attitude with regards the effect of recent fiscal policy.
• The MPC is also likely to vote to begin active sales of its gilt holdings, at the previously announced rate of £10bn per quarter.
• Further remarks on the hiking path will probably defer to the updated November meeting, when the new MPR (and forecasts) will be released.
• Looking at the timeline of data ahead, we see the stage being set for a strong dovish pivot at November’s MPR.

Market Implications

• We see value fading BoE hiking over the next 6 months, going long 2Y gilt, and re-entering / adding to relative gilt steepening vs EGBs and outright gilt steepening (2s30s).

Fiscal Boost to Support Dovish Pivot

The BoE’s job just got easier. While it still needs to balance the declining growth outlook with a significant overshoot of near-term, energy-driven inflation, the government energy price freeze makes the trajectory of both much more manageable. By our calculations, it will shave off c.3pp from inflation out to 2024 and prevent the (perhaps counter-intuitive) costly consumer credit expansion, which would have otherwise been necessary (Chart 1).

The full effects of the spend will only be clear next week when the details are announced. However, for now we expect the inflationary effects to be limited. The price cap is tied to energy usage, so it will end up relatively regressive, which should mean a higher proportion is saved at the £15bn injection provided in May. Similarly, proposed tax cuts, while expensive, are unlikely to produce a surge in spending, particularly when (again) they are regressive (NI cut) or benefit businesses. Additionally, it is likely that to balance the situation, the new PM will seek to cut spending elsewhere (including public sector employment), which will further soften the inflation effect in the medium-term.

50bp Again, But The Case for Under-delivery Grows

For now, with the labour market still very tight, and inflation remaining high, there is good reason to expect the BoE will repeat a 50bp hike.

• Why not accelerate to 75bp?
  • This would come on the back of a worsening inflation situation, which is clearly not the case.
  • While hawk Mann supports further front-loading, the bulk of the MPC does not appear to. Governor Bailey and Chief Economist Pill sit more in the ‘wait and see the effect on medium term’ camp.
  • The BoE is not in the same position as the ECB. The ECB started hiking eight months later, while benefitting from energy price caps for longer.
  • Given the new fiscal plan, a decision on altering trajectory makes sense once forecasts are updated – i.e. with the November MPR.
  • The BoE is likely to vote to begin active QT – providing a new source of financial condition tightening.
• Why not slow to 25bp?
  • With the labour market still hot, and the effects of fiscal policy unknown, there seems little reason to slow just yet.
  • As per Chart 1, monthly inflation is set to continue rising above trend for several months yet.

On this basis, we expect the BoE will hike by 50bp at next week’s meeting, which would be an under-delivery versus market pricing; currently pricing 70bp (Chart 2). Further out, there is even more room for an under delivery (Chart 3). As we have set out previously, by November MPR, the dovish pivot should be clear (Chart 4).

Lower Inflation Overshoot Points to Less Hiking

The BoE has, since the pandemic, hiked proportional to the average deviation in its Y1-Y4 forecast of CPI from target (Chart 5). In this context, the market’s pricing of c.1.5pp of hiking from August to November’s MPR, and 4.5% terminal rate make sense. However, with the updated inflation outlook (as in Chart 1), even including the fiscal boost, the average upside deviation falls to just 25bp. Add to the fact that this does not assume any recession, or include the impact of significantly higher market rates (which the BoE baseline forecasts will need to), and the average forecast may fall to an undershoot.

The Dovish Case Is Building

The macro forecasts now point to fewer additional hikes. The next domino to fall will be inflation expectations. This is the mast to which hawks such as Mann have pinned their flags. The effect of the energy price cap has not yet fed into surveys. The first survey it will hit will likely be the September Decision Maker Panel Survey (due early October). Even so the medium-term fears of recession are beginning to weigh on consumers. The August Inflation Attitudes Survey is already showing moderation – with its first decline since Q2 2021 (Chart 6).

Financial Conditions Are Rapidly Tightening

An important indicator of the effect of monetary policy, on the back of sterling depreciation and bond weakness, financial conditions are now at their tightest level since at least 2013 (Chart 7).

This move is likely to continue on the back of QT and heavy DMO issuance (to be confirmed next week) which we expect will drive further rates weakness. While it is likely that the new UK spending plan will not be financed entirely by gilt issuance, it is likely the weight of new duration from QT and DMO issuance will be a step change (Chart 8).

UK Economy Continues to Slow

Meanwhile, the UK economy is facing continued headwinds. Global growth is slowing, and Europe’s energy crisis is far from over. The catastrophic consumer crunch that would have occurred had the government not frozen energy prices has been averted, but that does not mean the consumer situation is fine. Even if YoY wage growth stay elevated at 5.5% (unlikely given falling job vacancies and slowing economic growth) real wates will remain negative until mid-2023. Meanwhile, next week’s new bank holiday for the Queen’s funeral will take a further bite out of Q3 output.

Fade BoE Hike Pricing, and Position for Gilt Steepening

We have previously highlighted the value in fading pricing for BoE hikes, and positioning for outright and relative gilt steepening. Clearly, this has since been proven premature. At this juncture, given the ECB dynamic, we now see value, once again, in all three.

For fading BoE hikes, we see the simplest representation as buying 2Y UK gilts, or receiving Mar23-settling GBP forward OIS swaps (previously we saw Nov22 as most attractive, but given the above timeline and the peak in hawkishness then, March allows for most room to perform.

For relative gilt vs EGB steepening, 2s10s Spain flattener vs UK steepener, again seems an effective representation of this.

Finally, for outright UK gilt steepening, 2s30s steepening matches with our longstanding strategic view that the change in pension deficits and labour market dynamic will see less buying into the ultra-long end of the curve.

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.)