GBP in focus: what will the BOE do next?

The chief focus at the start of the week is the Bank of England meeting on Thursday, alongside UK inflation that is due for release on Wednesday. After managing to get the UK yield curve under control after last September’s mini-budget crisis, the inability of the UK to control its inflation and extremely large wage gains, have caused market jitters to resurface. The UK’s 2-year yield has now breached the 5% mark, which is higher than the peak it reached back in September. 2-year yields are up some 7bps on Monday, the spread between UK and German 2-year yields is now nearly 2%. The surge in bond yields is not just at the short end of the curve either, the 30-year yield is also higher today and is close to its September 2022 peak. The fact that the entire UK yield curve has stepped higher and rates across the curve in the UK are much higher than their US and European counterparts is a sign that although Rishi Sunak has managed to restore credibility back to the UK government, there is still a premium on UK debt.

The premium issue related to UK debt is a key question for investors and one that could impact UK asset prices, especially government bonds, UK corporate credit and the pound. The reason for the premium could be due to high public spending needs due to the NHS, etc but it could also be a sign that the market has lost faith in the Bank of England to bring inflation under control and the UK government to boost growth. Unsurprisingly, this is not a good place to be. Surges in bond market volatility, this is the second time in nine months, makes the UK a less attractive place for foreigners to invest, it also makes domestic businesses and householders less likely to invest or move home/ buy new homes. This has huge implications for every sector in the economy, and ultimately could be what causes the UK’s long touted recession. The political trouble that this could stem from the rise in bond yields is also worth watching closely.

The question people want answered right now is how this crisis will be resolved and where will rates go next. The lazy answer would be to spout that this is a major crisis, and all hell will break out leading to protests on the streets. We do not believe that will happen for a few reasons. Firstly, the fact that UK bond yields have risen so far so fast, the 2-year yield is up more than 130 basis points in just over a month, is a sign of panic, but if Tuesday’s inflation figures, or the BOE meeting on Thursday can calm investors nerves then we would not expect yields to rise by the same amount in the coming weeks. Added to this, there are reasons to believe that the BOE will consider the fact that the markets are already doing some of the tightening for them, which should reduce consumption, and the need for too much hawkish talk later this week. Added to this, although wage growth surged in the three months to April, this is backward looking data. Wage growth, although broad based between February and April this year, was driven by large gains for the finance and business services sector, with pay growth also noticeable in the public sector. Since many finance sector workers negotiate their wage packages in the first quarter of the year, we expect this upswing to be temporary. Likewise, some public sector workers have already agreed their pay rises after a period of strikes in the last 6 months, which may have also led to a one-off boost to wage growth. Thus, the BOE may choose to look through this data when they decide what the Bank Rate should be later this week.

Thus, we do not expect a rise of 50 bps, instead we think that the BOE will raise rates by 25bps. The market is currently pricing in just over 25bps of rate hikes, so a 25bp hike only may be considered dovish. The inflation data that is scheduled for release on Wednesday, is also expected to show consumer prices falling a couple of notches to 8.5% from 8.7% YoY, monthly price growth is expected to fall to 0.4% from 1.2% in April. Core prices are expected to remain steady at 6.8% YoY. However, more importantly are producer prices in our view, as producer prices are an important input to CPI. Producer price growth for May is expected to be -0.6%, double the decline that we saw in April, the annual rate is expected to fall to 2.4% from 3.9%, which is much closer to the BOE’s 2% target rate. Thus, the decline in producer prices, could be the silver lining from this inflation report. Added to this, we believe that the risks are to the downside for the May inflation report. Firstly, the wet weather may have kept people indoors, secondly, after April’s upside inflation surprise, many analysts may have rushed to upgrade their May forecasts. Thus, this inflation report is hard to predict, but one to watch.

Market view

Markets are in a risk off tone at the start of the week, as investors digest news that China will not be adding stimuli to its economy after some recent weak economic data readings. China doesn’t have an inflation problem; however, it does have a problem with its real estate sector and bad loans, which tends to be a major drag on the economy. Thus, any traders who were expecting China to be a positive factor for risk in the second half of the year may need to look elsewhere.

Gold is also one to watch, it fell below the $1950 mark at one stage today as the investment case for gold gets eroded by 1, the stronger dollar, and 2, the fact that central banks (bar the BOE) seem to be getting inflation under control and China has not imported Western inflation. Thus, there could be further losses for the yellow metal in the coming weeks. Brent crude is up a touch on Monday, and is trading back above $76 per barrel, however, there is now significant uncertainty about where the oil price goes next and if it can recover, even with the recent Saudi production cuts because the China authorities do not seem willing to throw stimulus at their economy.

The FX market is also on our radar this week, as we wait for the BOE. The dollar is benefitting from the risk off tone at the start of the week and is leading the G7 pack higher. What is interesting to us, is that even though GBP/USD has backed away from the $1.28 highs from last week, GBP/USD is up more than 3% in the past month, and the pound is also higher by more than 1.6% vs. the euro in the same period. Back in September, the pound sunk as UK Gilt yields rose; cable was approaching parity, but now it is close to $1.30. Thus, the FX market is not acting like the UK economy is on the precipice of disaster. We choose to be optimistic. While the surge in bond yields is painful, we think it will prove temporary. As stated above, the May inflation report could surprise on the downside, and the focus may shift to negative producer price growth. If that happens, then it will be much easier for the BOE to embark on some soothing words to get the bond market back under control. However, good news for bonds could be nad news for the pound in the coming days.