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Hawkish comments from the Bank of England certainly caught the markets flat-footed this week, resulting in a sharp correction in interest rate projections. Talk that the starting gun has been fired on the normalising of UK interest rates is premature.
Having kept interest rates unchanged, the Bank of England’s post-policy meeting commentary disclosed that the majority of its nine members now thought a rate increase in the coming months was appropriate. Given the BoE typically coincides any change in strategy with the inflation report, November certainly seems the most plausible timing for any hike. As a result, the five-year GBP swap rate climbed to over 1.00%, having started the week at 0.65%. Therefore, the market is indicating a 60% chance of a rate increase by November and an 80% chance by February, with those respective percentages being only 20% and 35% last Monday.
Commentators are rightly wary of reading too much into the Bank’s forward guidance given numerous false dawns, namely in 2014 and again in early 2016. However, the Bank’s position on this occasion was supported by Gertjan Vlieghe, an external member of the MPC particularly known for being an ’uber dove’. Having been an advocate for keeping rates low, citing the damage of a premature increase only last month, Vlieghe appeared to change his tone during a speech in London in which he claimed that “...we are approaching the moment when the bank may need to raise rates”.
Part of the reason these comments came as a surprise to the market was that data released last week continued to show little signs of real wage growth despite record low levels of unemployment, at 4.3%. A conundrum that has suppressed global monetary policy was further evidenced this week, with data showing average pay increasing by only 2.1% for the last three months whilst inflation for August hit 2.9%, the highest level in five years, and expected to exceed 3% in October. It was therefore unexpected that Vlieghe’s changing outlook was partly driven by rising wage pressures in which he evidenced private sector growth for the last five months of 3.00%, a level that exceeds inflation. An interesting statistic when one takes into account the growing pressure the government is under to remove the public sector pay cap. Although only modest increases are being touted, it would certainly contribute to overall wage growth and therefore provide the MPC with a stronger rationale to raise interest rates.
This is further evidence that, at this point of the business cycle and with unemployment at a 42-year low, there doesn’t necessarily have to be a significant shift in the data for policymakers to tighten monetary policy from the prevailing emergency levels of the last seven years. Talk of normalising monetary policy in the UK is excessive, with any rate increase likely to be a one-off as policymakers closely monitor the implications of this move. Added to that, if the guidance around any increase is managed correctly - and that is by no means a certainty for this Bank of England Chancellor - then a further increase will be unwarranted in the short term. Instead, higher interest rate expectations and a steepening of the yield curve should serve their purpose in communicating to the market. That being the case, any further rate increases would be unlikely until the middle of next year at the earliest.
The currency markets also witnessed significant movements, with the pound reaching 1.36 against the dollar, a 4% increase over the week and the highest levels since 23 June 2016, the day of the EU referendum result. Whilst welcome news, the pound will continue to face headwinds. None of these will be stronger than the ongoing Brexit negotiations, the latest round of which has been delayed by a week. It increasingly appears that in order to achieve meaningful progress, she will have to endorse a financial settlement, whilst being tactful in its presentation to appease the British electorate as well as her own party. One such suggestion being widely touted is agreeing to a transitional agreement that would allow any cost to be spread over time.
Across the Atlantic, the Federal Open Market Committee (FOMC) meeting should be far less eventful, with rates remaining unchanged. However, the market does appear to be gearing up for a hike in December following firmer inflation data for August of 1.9%. The increase from 1.7% the previous month has meant the probability of a hike by the end of the year now stands at 55%. We would suggest that this is probably slightly overdone, with the Fed unlikely to raise rates again without more sustained evidence of inflationary pressure. A hike early next year is more realistic. The Fed will, however, announce a modest start to the normalisation of its balance sheet this week, although with the initial amount likely to be too small to get the markets’ attention.
All views expressed here are the author’s own and are based on information and data available at the time of writing
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