BOE: the rate rise that never was

At the start of this week market data showed that derivatives traders were pricing in a 64% probability of a 15-basis point rate rise from the Bank of England on Thursday. As it turns out the Bank of England decided not to “follow the market”, and instead voted to keep interest rates on hold, with 7-2 voting to keep rates at a record low of 0.1%. Added to this, the BOE voted 6-3 in favour of continuing the existing programme of UK government bond purchases and its stock of corporate bond purchases, which means that its total asset purchase programme is £895bn. There had been some expectation that the BOE would end this programme early, but that did not happen as the Bank delivered one of the largest central bank dovish shocks in recent memory. 

The unreliable boyfriend strikes again

Since the announcement at lunchtime UK time on Thursday, Andrew Bailey and others on the MPC have been called “unreliable boyfriends” who use hawkish rhetoric to tease financial markets, and some analysts have even questioned the bank’s credibility. This has unleashed the “great” unwinding of the hawkish Bank of England trade. Sterling has fallen across the board, while GBP/USD is down nearly 1% at the time of writing. Added to this, the UK Gilt market has reacted in a rapid and dramatic fashion, with a sharp steepening of the UK yield curve. 2-year UK yields have fallen some 14 basis points on the back of the BOE decision to 0.56%, while 10-year yields have fallen a more modest 8 basis points, which has pushed 10-year UK bond yield below 1%. One question that we have pondered in the wake of this decision - if the BOE had raised rates, what would have been the impact on UK asset prices? We tend to think that 15 basis points would have not made much difference to the overall UK economy, thus it is difficult to see why the BOE wrong-footed financial markets like this. However, the future outlook for UK interest rates was significantly less hawkish than we had expected, which is the main driver of weaker sterling and lower UK bond yields in the aftermath of this meeting. Thus, even if the BOE had raised interest rates on Thursday, sterling may still have weakened considerably.

What’s changed at the BOE:

·      Labour market outlook: the BOE justified its decision by saying that there was a high degree of uncertainty around the labour market as the furlough programme came to an end in September. The BOE said that there was a million jobs that are likely to have been furloughed just before the furlough scheme came to an end. However, the Bank did note that are few signs of an increase in redundancies, and job vacancies hit a record high in the three months to August, with 1.1 million job vacancies recorded. Thus, since the labour market is a lagging economic indicator, the BOE may want to see a few more months’ worth of jobs data before it is willing to pull the trigger on rate rises. This slightly reduces the chance of a December rise, in our view, and it could keep sterling on the back-foot for the medium term. 

·      We have noted in previous reports that it seemed ridiculous for the BOE to hike rates at the same time as continuing with its asset purchase programme. The BOE was also aware of this and may wait until the asset Purchase programme expires at the end of this year before hiking rates. 

·      It is worth remembering, that the BOE has said that it will not start selling back the assets on its balance sheet until interest rates reach 1%. Thus, after the recent sharp rise in global sovereign bond yields, the BOE may be wary of hiking rates too quickly so that it does not have to sell the assets on its balance sheet into a market where bond prices are falling (yields are rising). This “dovish shock” could have been designed to preserve the integrity of the BOE’s balance sheet and to ensure there is not excess upward pressure on UK sovereign bond yields when the UK debt to GDP ratio is as high as it is currently. 

Overall, the BOE said that it expected interest rates to rise “modestly” in order to reach the BOE’s target inflation rate. By using this word, the BOE is clearly trying to talk down the prospect of rapid rate rises, especially in comparison to some of our global peers like the Federal Reserve and the ECB. We think that the BOE could raise rates in December, however, the market needs to be careful in how they react to BOE speeches and interviews in the future. The BOE pushed back on market pricing that expects a benchmark rate rise to around 1% next year. The BOE’s inflation forecasts, under the assumption of rates at 1% by the end of 2022, showed inflation falling below the target 2% rate, thus the market should interpret this as too aggressive. We now expect the UK bond yield swaps market to rapidly re-price its expectations for UK interest rate increases in 2022 and beyond, with the UK likely to track the US rate path more closely in the coming years, even if it does raise rates next month. 

Labour market data now key

While interest rate increases are expected in the near future, we think that they will be data dependent. The BOE now expects inflation to peak at 5% in April next year, but it has also trimmed its growth forecast for 2021 from 7.25% to 7%, and it expects the UK economy to return to its pre-pandemic size in Q1 2022, rather than this year. It expects labour shortages and supply chain issues to continue to dog the UK economy into 2022, and it forecasts GDP next year to expand by 5%, down from its previous forecast of 6%. 

The market impact 

The BOE’s forecasts suggest that today’s decision was made between a rock and a hard place. On the one hand inflation is surging, on the other they are revising down their growth forecasts and maintaining their bond purchases. BOE speak is not to be trusted, and we could see more volatility in UK asset prices as a result of today’s MPC decision. GBP/USD could find it hard to recover back to last week’s highs around $1.38, for now the $1.3415 low from 29th September looks like decent support. We do not expect a rapid recovery in GBP after Thursday’s declines, and we may only see GBP bounce back if we get better data on UK employment when it is released later this month. We expect the UK yield curve to continue to steepen, which should be good news for UK stock market prices and the FTSE 100 and 250 indices overall. However, the BOE’s decision to keep rates on hold is bad news for banks, since lower interest rates that stick around for a longer time period should hurt their income from mortgages and loans. UK bank stocks are the weakest performers on the FTSE 100 on Thursday, with NatWest and Lloyds Banking Group down more than 4% each, and Barclays down more than 2.5% in the wake of the BOE decision. In contrast, today’s BOE news has lifted consumer discretionary stocks and the real estate sector. Overall, the FTSE 100 was up more than 0.4% after the BOE meeting. The BOE decision and the low interest rate environment in the UK remains supportive for the FTSE 100, and we think that the technical outlook remain constructive for further gains.