Opinion editorial by Stuart Cole, head macro economist at Equiti Capital

Market pricing sees interest rates tightening around 115 basis points by this time next year, starting as early as next month.  When you consider that until recently market focus was whether the first interest rate rise might come by mid-2022, with only around 50 basis points in tightening seen by end-2022, this is a remarkable sentiment shift.  But what is this sentiment shift predicated upon, and is the market getting ahead of itself?

MPC turning increasingly hawkish?

• Expect a rate hike but not as far as the market is suggesting
• Prices increases are becoming embedded

Financial markets are widely anticipating the Bank of England (BoE) will raise interest rates at its November or December meeting.  Recent comments from Governor Andrew Bailey, that it would “have to act” to reduce inflationary pressures, have been interpreted as signalling rate rises are coming, even though he was largely referencing the need to avoid inflation expectations becoming unanchored.  The result has been sterling overnight index swaps showing rates rising to around 1.25% by November 2022, a significant shift in expectations and a far more bullish outlook than seen hitherto.  Significantly, the BoE has not pushed back on this move, suggesting tacit approval for tighter financial conditions, and fuelling expectations that official policy rates will be raised too.

The fact that a rate hike is being anticipated as soon as next month raises the question of whether the BoE now views inflation as more sustainable than hitherto and is worried that continued inaction will lead to it falling ‘behind the curve’ policy-wise, resulting in rates tightening faster and further than would otherwise have been the case.  Certainly the ‘transitory’ argument has looked questionable for some time, with rising wages, surging energy prices and producers increasingly expecting to raise prices going forward, all suggesting price rises are becoming embedded.

A clearer picture on this issue will come next year, when it will be seen if CPI drops back towards its target level, as the BoE continues to suggest.  If this does indeed transpire then we are unlikely to see rates rise as far as the market is suggesting.  But if the BoE is wrong then rates around the 1.25% level next November does look possible, if not entirely plausible yet: possibly we are seeing the market hedging against such a scenario rather than evidence of it being the actual base case per se.

Will tighter monetary policy stifle the economic recovery?

• End of the furlough scheme
• Removal of social security payments
• Remove demand from the economy

The biggest challenge facing the BoE is tighter policy stifling the economic recovery, a recovery that is already showing signs of slowing in the face of increasing headwinds: the ending of the jobs furlough scheme, the removal of enhanced social security payments and the fiscal tightening already announced will all act to remove demand from the economy.  The BoE risks applying a further drag to the recovery at precisely the time additional support might be required.  Indeed, GDP data already shows economic growth slowing, and with the impact of the recent rise in yields still to be seen.

• BoE’s asset purchase programme
• Interest rates forecast to reach 0.50% by February 2022
• £40 billion off the Bank of England’s balance sheet
• Significant tightening might be required

Compounding this direct monetary tightening is also the impact the cessation of the BoE’s asset purchase programme will have.  With net purchases scheduled to end this year, the question of whether the BoE will also begin to unwind its balance sheet has suddenly come into focus too.  With interest rates forecast to reach 0.50% by February, the BoE’s threshold for allowing maturing gilts to roll-off instead of being replaced will be reached: what was largely seen as a tail-risk is now suddenly a base case scenario and one which will be hitting the gilt market at the same time as it is being forced to address the absence of BoE buying as well as rising interest rates.  With close to £40 billion of debt potentially rolling off the BoE’s balance sheet by end-2022, how it handles this issue will be crucial if yields are not to move even higher.

Finally, a further complication is that even after initial increases, rates will still be at historically low levels.  Consequentially, a significant degree of tightening might be required before they materially start to bite and influence consumer behaviour.  The mechanics of this suggests a more aggressive path to higher rates may be needed for this ‘pinch point’ to be met and tighter policy to become effective.

Is the anticipated tightening path too aggressive?

• PMI release show wages rising
• Supply chain issues driving input prices higher

After effectively signalling for a few weeks that a rate hike is imminent, to not do so now risks damaging the BoE’s credibility, something it will be keen to avoid.  However, given that no current MPC member has voted for a rate rise in previous meetings, to suddenly see the MPC change course as soon as November seems extreme.   Accordingly, a modest rise in December appears to be the most likely outcome, with a minority of votes being cast for such a move in November as preparation.

But the path thereafter looks more uncertain.  With GDP and retail sales figures pointing to growth slowing, but PMI releases showing wages rising and supply chain issues driving input prices higher, the BoE will want to tread cautiously while it tries to determine whether inflationary forces really are transitory or not.  Accordingly, a more modest pace of tightening than the 1.25% the market is anticipating appears the most likely outcome – while the MPC may also quietly welcome a moderate deterioration in the labour market to dampen down earnings growth.

‘’This material is provided for informational purposes only and does not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by Equiti Capital. This material is not, and is not intended to be, a “research report”, “investment research” or “independent research” as may be defined in applicable laws and regulations worldwide. Please see the full disclaimer here: https://www.equiticapital.co.uk/media/11057/disclaimer.pdf