PGIM Fixed Income - Thu, 09/21/2023 - 15:11

The BoE's "Table Mountain" Approach Sees Rates Highest for Longest

The Bank of England (BoE) kept its Bank Rate on hold at 5.25% today. The UK’s economic backdrop is weak, so we believe that the BoE will keep interest rates at this level for the near future.

The BoE’s “hold” may protect the UK economy, and it may support prices for government bonds and risk assets such as corporate debt. But if it hurts the pound sterling, today’s decision could raise consumer price inflation, which is sensitive to the exchange rate.

Our Take on the Meeting

Given the elevated inflation backdrop, we’re somewhat surprised that the BoE kept interest rates on hold. This is the BoE’s second dovish signal, after it stepped back from 0.50 percentage point (pp) hikes to a 0.25 pp hike at its previous meeting.

Granted, recent data points to a weakening economy and a softening nominal environment. That said, today seemed to us like the most dovish statement and decision that has recently come out of a major central bank. The BoE gave little, if any, forward guidance, nor the conviction that rates might go higher if inflation remains high. Instead, it emphasized the following factors behind its decision:

  • Inflation is falling faster than expected, but services inflation can be volatile.
  • The BoE recalled that its latest projections, conditioned on a market-implied path for Bank Rate to 5.5%, showed inflation in the medium term falling below its target of 2%.
  • Pass-through from previous rate hikes is yet to be fully felt in the real economy, which is visibly weakening – and fast.
  • Wage growth was “stabilising” on alternative measures to average weekly earnings (AWE), which is key data on wage growth.
  • Material weakening in the labor market would likely only happen with a significant delay.

All this suggests that inflation and policy rates in the UK will remain high for some time. Alongside higher rates for longer, the BoE increased the pace of its balance sheet runoff, in line with expectations, to £100 billion from October over the next 12 months. The BoE noted that the impact of quantitative tightening (QT) has been “modest,” but that QT is contributing to tighter financial conditions at the margin.

The BoE’s latest policy decisions lack a signal that Bank Rate could rise again, and immediate economic data is likely to continue to come in weaker. As a result, our view is that the BoE will not raise Bank Rate at its next meeting, but keep it on hold at 5.25% for the foreseeable future.

Further inflation shocks may hit, including through a weaker pound sterling, given that consumer prices are sensitive to the exchange rate. In that case, the BoE may need to resume chasing inflation through higher rates. Its “Table Mountain” approach to monetary policy contrasts with the European Central Bank’s “Matterhorn” approach, which probably leaves the BoE “highest for longest” among central banks in developed markets.

Investor Reaction

Keeping rates on hold was a tricky bet for the BoE. This week’s downside surprise in UK services inflation allowed the BoE to be cautious, especially given weaker growth. At the same time, the inflation fight doesn’t end here. The UK economy continues to face high wage inflation and a low unemployment rate.

Today’s BoE hold contrasts with the ECB’s hike last week. Both central banks face challenging growth prospects and high inflation, but the ECB delivered a "dovish hike." To make things even more interesting, the Fed offered a different flavor by delivering a "hawkish pause" on September 20.

From investors’ perspective, the BoE’s hold raises three interesting points. First, all three central banks are approaching the end of their aggressive tightening cycles. Second, each of them has been comfortable signaling that policy rates may need to stay “higher for longer” to ensure inflation stays under control. Third, they each face markedly different growth backdrops. In the U.S., economic momentum has been strong until recently, but the opposite has been true in the UK and the euro area, where growth momentum has been weakening since May (Figure 1).

Figure 1: Activity has weakened in the UK and the euro area, but it has remained strong in the U.S.

Source: Citi. Citi data change indices measure data momentum. Higher/lower values indicate stronger/weaker momentum in the preceding three months, relative to the preceding 12 months.

This has important implications for investors.

Starting with government bond markets, the bar for central banks to embark on rate cuts is high. This means that short-dated interest rates support longer-dated bond yields. Government bond issuance in the U.S., the UK, and the euro area, as well as increased macroeconomic uncertainty, will probably keep term premia high at the longer-dated end of these governments’ yield curves. This situation makes calling the next directional move difficult. But the good news is that investors are no longer starved for yields, as before the pandemic.

An important difference, mentioned above, is that the UK’s growth backdrop, along with that in the euro area, is much weaker than in the U.S. The BoE has been looking to pause, so gilt yields are off their cyclical highs. This is different to German Bund yields: those remain close to their cyclical highs, mainly because the more hawkish ECB is restricted by its inflation-targeting mandate.

Figure 2 shows the unusual divergence at the short-dated end of the UK and German yield curves. Given the euro area’s weak growth prospects, the short-dated end of the German yield curve looks high to us. The U.S. Treasury market sets the global tone for rates, so the Fed’s hawkish message only makes the situation worse for core euro area bond yields.

Figure 2: Two-year German Bund yields have stayed close to their cyclical highs but two-year gilt yields in the UK have fallen recently. (%)

Source: Bloomberg

Risk assets are also in a tricky spot. After aggressive policy tightening, the BoE’s pause seeks to protect growth. This may help risk assets at the margin, but it hurts the pound sterling, relative to currencies supported by high interest rates such as the U.S. dollar and the euro (Figure 3). Add to this the UK’s modest growth prospects, and sterling faces even more trouble.

Figure 3: Lower UK yields have led to a weaker sterling, relative to the euro and the U.S. dollar.

Source: Bloomberg

As for euro area risk assets such as corporate debt: investors in these assets have gotten used to the combination of lackluster growth, lower volatility (helped by the inflation fight), and scarce issuance. But one factor that investors have swept under the carpet is the lagged effect of monetary policy. The ECB’s further tightening last week was a wake-up call.

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