Bank of England goes nuclear on rates, but the pound doesn’t follow suit

The major news at the start of this week is that the Bank of England are now expected to be the first of the major central banks to hike interest rates, after BOE Governor, Andrew Bailey, said on Sunday that a surge in energy prices would have a longer-lasting effect on inflation, which raises the chances of “embedded expectations”, which is why he was using his platform to signal that the Bank of England “will have to act”. Two-year UK bond yields surged 14 basis points on Monday to more than 0.7%, which is the largest single day move that I can remember, and which pushes the 2-year yield to a 2.5 year high. Traders are now making bets that the BOE will hike rates as early as next month, where rates could rise to 0.25% from 0.1% currently. The market is now expecting that UK interest rates could reach 0.5% in February and 1% by August. 

Assessing the risks of a misstep by the BOE 

To put this move in some context – prior to the BOE’s September meeting, only one increase in rates was expected by next summer. Monday’s move at the short end of the yield curve has shifted the dynamics in the UK Gilt curve. Earlier this year, the reflation trade – where growth and cyclical stocks were rising – led to a steepening of the UK yield curve, which caused long-dated bond yields to rise. This meant that the market thought that after a decent period of growth then interest rates would rise. However, on the back of Bailey’s comments, the market now thinks that rates will rise at a much faster pace, which increases the prospect of a sharp halt to economic growth in the near to medium term, and it also increases the chance of a policy mistake. However, the markets have not yet reacted to the sharp rise in near term interest rate expectations at the start of this week. GBP/USD was down a touch at 0.11% on Monday, while the FTSE 100 was down 0.4% and the FTSE 250, which is more sensitive to changes in UK interest rates than the bigger, blue chip index, was basically flat, down 0.06%. 

QE and rate hikes, pull the other one… 

So, is the market taking Bailey and co. at the BOE seriously? We think that the BOE is developing a credibility problem. Firstly, not that long ago the Bank of England were telling UK banks to prepare for negative interest rates, that isn’t going to happen, thus that exercise was a waste of time. Secondly, the market now thinks that the BOE will hike rates at the same time as it completes its QE programme, thus the bank will be hiking interest rates at the same time as buying assets, which should keep interest rates under control. This seems counterproductive and is extremely confusing. Surely hiking rates and at the same time as performing QE will cancel each other out? In fairness to the BOE, QE is due to end in February, and part of Monday’s move in 2-year Gilt yields was technical, some traders who had bet on a steepening UK yield curve had been forced to throw in the towel, which added to the upward pressure on short-dated Gilt yields. Added to this, Andrew Bailey’s tough talk could also have been designed to help the Bank of England. They are obviously worried about being behind the curve when it comes to inflation, thus by talking tough Bailey has won – he has triggered a sharp rise in bond yields, which will do some of the hard work of tightening for the BOE – for example, if bond yields remain at this high level then the BOE may feel less inclined to hike rates at the current pace priced in by the market. This is why we think UK asset prices had a fairly sanguine reaction to Bailey’s tough talk on inflation.

Watching UK CPI 

The proof is usually in the pudding. Thus, this week’s CPI figures from the UK that are scheduled for release on Wednesday will be worth watching closely. The market is expecting 3.2% YoY for September, which would be unchanged compared with August. The retail price index is expected to moderate slightly to 4.7% from 4.8%, while the core consumer price index is also expected to moderate to 3% from 3.1% in August. These are high figures, but do they really support nuclear talk from Andrew Bailey about rate rises? Likewise, inflation expectations soared in August to 4.1%, from 3.1% in July, but could expectations fall before year end? Our views on UK inflation and the Bank of England are based on two factors: firstly, inflation could moderate next year, as base effects weigh on the YoY inflation rate, especially in the second half of 2022. Secondly, will rate increases from the BOE actually help to ease UK inflation? We are sceptical, since much of the upward price pressure in the UK’s inflation pipeline is imported and due to global supply chain problems, which cannot be influenced by the BOE. Thus, we remain slightly sceptical of the current market expectations for UK rates in the next year. If we see a small moderation in UK price pressures this week, then the BOE may hike rates in November, while at the same time dialling down their hawkish rhetoric. 

What does this mean for the pound? 

From a technical perspective, as long as $1.27 support in GBP/USD holds, then this paves the way for further gains. However, we think that GBP could be fairly muted in the coming weeks, this is because real yields, when adjusted for inflation, are negative, even after today’s move higher, thus a hawkish BOE at the same time as inflation is rising is not as good for the pound as it would appear to be on paper. While we wait to see how the BOE reacts to the latest inflation print, and whether any of the doves dare speak out, we think that progress on the EU/ UK discussions on the Northern Ireland protocol in the Brexit agreement could be more important for the pound’s direction in the medium term. EUR/GBP bounced back after sliding to its lowest level since February 2020 last week. We think that this pair looks like it is stretched to the downside, thus we think GBP could struggle vs. the euro this week, and trade sideways vs. the USD. 

PMI clues to impact of economic headwinds on global economy 

Elsewhere, the first reading of October PMI reports for the UK, Eurozone and the US will be released at the end of this week. The market expects that these indices will all show that the major western economies are growing. However, these indices will be watched closely to see how these economies are coping with supply chain problems, rising energy and gas costs and the shortage of goods caused by major delays at the world’s biggest ports.