The Bank of England Buys Itself Time

The BoE delivered no surprise today when it raised its main policy rate (“Bank Rate”) a further 25 basis points (bps) to 4.5%. But the Bank’s messaging distinguished it from the Fed’s and the ECB’s decisions last week.

The Fed signaled a likely pause last week, and the ECB remained hawkish, with the prospect of further hikes. By contrast, the BoE kept the door open to either. On the one hand, it expects nominal price pressures to remain resilient, pointing to higher rates or higher-for-longer rates. On the other hand, the Bank’s tightening to date has been substantial and is yet to feed through to the real economy.

The key question for us is whether UK policy rates can sustainably decouple if and when the Fed cuts rates, possibly later this year. In such a scenario, we see higher-for-longer UK rates as likely – i.e., rates peaking close to the current level and remaining there for longer as inflation slowly grinds back to the 2% target.

Our Take on The Policy Meeting

Against a fragile global backdrop of banking stresses and U.S. debt-ceiling woes, the BoE did well to not deliver an additional surprise. But the Bank’s updated assessment of the UK economy was interesting. The Bank revised its GDP outlook markedly higher, such that it no longer expects the UK to slip into recession this year. That said, the growth outlook remains exceptionally weak.

Also interesting was the BoE’s assessment that, to date, the impact of U.S. banking stress on UK credit conditions has been small. This judgment aligns with our view that there has been limited contagion from the U.S. banking sector to Europe. However, the UK is not immune to spillovers from the U.S. A weaker U.S. economy would translate into reduced demand for UK exports and slower overall economic activity, potentially reducing the need for further rate rises.

Finally, the Bank’s messaging focused on the prospects of prolonged above-target inflation. It now expects second-round effects of higher wages and inflation expectations to take longer to unwind than when they emerged. This reassessment of the stickiness of inflation would, at the margin, translate into further interest rate rises.

Our base case is that the BoE has bought itself time to assess where it goes next with interest rates. If the UK economy evolves in line with its projections, we see Bank Rate peak at its current 4.5%, with perhaps another quarter point hike in June or August before pausing. We see resilience in inflation as indicating higher-for-longer interest rates, rather than ever higher rates.

Market Reaction

As explained above, the Fed, ECB and BoE’s 25 bps increases mask different postures, with the BoE showing the steadiest direction of travel. The BoE appeared confident today that it has done enough to bring inflation back to target. There was little in its press release or press conference to alter market pricing in Gilts or other UK markets. However, there are three important points of note from a market perspective.

First, UK economic data has been more challenging for markets than data in the U.S. and the eurozone. In particular, UK core inflation remains stubbornly high, relative to U.S. inflation, which started to fall last September (Figure 1). UK activity has also been better than feared. UK economic data surprises, for example, have been positive and rising in recent months, in contrast with the U.S. and the eurozone, where they have decelerated (Figure 2).

Figure 1: UK Core Inflation Versus U.S. Core Inflation (%)

Source: Bloomberg, PGIM Fixed Income. As of 11 May 2023.

Figure 2: UK Economic Surprises are Positive and Rising, while U.S. and eurozone Economic Surprises Are Falling (Index Level)

Source: Citi. As of 11 May 2023.

Second, this diverging economic data has led to diverging expectations for central bank rates. Investors expect the UK to raise rates or keep them higher for longer as the U.S. embarks on a rate-cutting cycle. Market pricing indicates two more BoE hikes by September, but expects the U.S. to cut rates once by then. These are truly diverging policies (Figure 3).

Figure 3: Policy Divergence Between the BoE and the Fed is notable (%)

Source: Bloomberg, PGIM Fixed Income. As of 11 May 2023.

Finally, we think that the above divergence may eventually ease for two key reasons.

  • First, from a pure policy perspective, the Fed rate cuts priced into short-dated U.S. interest rates could reverse, given signs that core services inflation (ex-shelter), c. 55% of the core PCE (Personal Consumption Expenditures) basket, remains persistent. At the same time, investors’ anxiety associated with U.S. regional banks could ease. However, developments with the U.S. debt ceiling may lead to anomalies across the short-dated end of the U.S. yield curve.
  • Second, the UK Gilts market doesn’t seem to reflect that the effect of energy prices on UK inflation will reverse in coming months, leading to significant downside surprises. That should lead to lower UK interest rates and a steeper UK yield curve. The UK 2-year/10-year Gilts curve, for example, has flattened since mid-April, while the U.S. Treasury 2-year/10-year yield curve has steepened by c. 20 bps. Relatedly, the easing of the UK versus U.S. interest rate differential could lead to some reversal in the GBP/USD exchange rate, after its 4% rally since early March.

Overall, the BoE’s decision didn’t surprise investors. If anything, the Bank’s messaging was less definite in term of direction, compared to the more hawkish ECB and more dovish Fed. Investors are, however, pricing in an important policy divergence between the Fed and the BoE. Interesting investment opportunities could emerge if that divergence doesn’t fully materialize.

Figure 4: The UK Gilts 2-year/10-year yield curve has flattened over the past month, while the U.S. Treasury 2-year/10-year yield curve has steepened (bps)

Source: Bloomberg, PGIM Fixed Income. As of 11 May 2023.

The comments, opinions, and estimates contained herein are based on and/or derived from publicly available information from sources that PGIM Fixed Income believes to be reliable. We do not guarantee the accuracy of such sources or information. This outlook, which is for informational purposes only, sets forth our views as of this date. The underlying assumptions and our views are subject to change. Past performance is not a guarantee or a reliable indicator of future results.
Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of 5/11/2023.

For Professional Investors only.  Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. All investments involve risk, including the possible loss of capital.

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PGIM Fixed Income
PGIM Fixed Income

PGIM Fixed Income is a global asset manager offering active solutions across all fixed income markets. The company has portfolio management and research teams in Newark, New Jersey, London, Amsterdam, Zurich, Munich, Singapore, Hong Kong, and Tokyo. As of December 31, 2022, the firm has $770 billion of assets under management, including $350 billion in institutional assets, $169 billion in retail assets, and $251 billion in proprietary assets. Nearly 1000 institutional investors entrust PGIM Fixed Income with their assets.

Rupal Shah
Principal, Client Advisory Group
655 Broad Street
Newark, NJ, USA 07102

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