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Pound and gilt yields down after Bank of England holds rates and overhauls QT
Neil Wilson
Investor Content Strategist
Note: This is marketing material. This article is not investment advice, capital is at risk.
The Bank of England left rates on hold at 3.75% with a 6-3 vote split as expected. The BoE also trimmed QT to a pace of £46bn a year, down from £70bn currently with £20bn of this in the form of gilt sales alongside maturing debt.
Notably, the overhaul of the QT programme will see it pause all gilt sales until April 2027 while it consults with the government on selling gilts direct to the Debt Management Office at market prices, instead of holding its own auctions, which could further ease some of the upwards pressure on yields. It's having "robust" discussions with government still on this - seems they cannot yet agree. But it's also stopped selling ultra-long gilts, keeping around £120 billion of bonds that mature in 2049 or later on its balance sheet, whilst unwinding shorter maturities. After facing a lot of criticism for its active gilt sales, which made it an outlier among central banks in terms of executing QT, it looks like the BoE is finding ways to reduce pressure on the long end without abandoning the policy altogether. Members of the Monetary Policy Committee may be mindful of the 20-40bps impact QT has on long-end yields. Note also that we've just entered the OBR's forecasting period for the Budget, so the Chancellor will be thankful for rates to fall. The showed up at the long end with 30yr yields down 11-12bps on what amounts to a BoE version of the Fed's 'Operation Twist'. The decision to pause all gilt sales until April may also reflect the Bank is worried about volatility around the ongoing Iran war and US midterms.
GBPUSD broke down further to make new lows since 30 July to test old support/resistance level at 1.3360 with sterling offered on a dovish reading from the statement, while gilt yields were lower with the 10yr backing off about 8bps. There has been a slightly dovish read from this one with markets pricing out some of the aggressive tightening that had been seen in the curve. Why? Well apart from the measures to adjust gilt sales (which may be less material in their effect than the signal it sends), the doves continue to hold sway and none was persuaded to turn hawk. However, it does look like governor Andrew Bailey and rate setter Clare Lombardelli are moving closer to a hike in November, which would tilt things in favour of a November hike. If the conflict continues “the case for raising Bank Rate is building” (Lombardelli) and “it is likely policy may have to tighten” (Bailey). Similarly, Dave Ramsden said were "upside pressures on the inflation outlook to continue to build, there could be a case for increasing bank rate”. Sarah Breeden noted that if inflation risks crystallise it would be “increasingly appropriate for Bank Rate to respond”.
Wait and see remains the order of today but things can change. The BoE says there has been "little evidence" of material second-round effects in price and wage-setting, but the risks to the inflation outlook "are tilted to the upside, and more so than at the time of the July Monetary Policy Report".
The decision to hold rates is entirely consistent with its recent messaging. It's also consistent with inflation so far remaining entirely a supply shock story. Inflation is elevated but not alarmingly so, growth is mediocre, and the economy does not resemble the overheating conditions of 2022. The hurdle for another rate hike remains high, which means markets still appear to be pricing too much tightening risk and too little probability that the next move is ultimately lower rather than higher. Nevertheless, the BoE warned that inflation would hit 4% early next year and that policy would have to tighten "if the conflict in the Middle East persists for an extended period, as appears to be the case, and the risk of second-round effects emerging increases".
Reasons to hold
1. This is not a repeat of 2022. Higher inflation is being driven mainly by energy and fuel costs rather than a broad-based resurgence in domestic inflation. Unlike 2022, there is little evidence of a wage-price spiral, excess demand, or the post-pandemic labour market distortions that previously worried policymakers. This is not 2022 - the labour market is in a far worse place, workers lack the bargaining power they had then, rates are already restrictive and not at the zero lower bound, and we don't have the huge post-pandemic demand impulse that unleashed prices and inflation expectations became unanchored.
2. The labour market is cooling. The UK labour market has softened materially. Rising unemployment, falling vacancies and slower wage growth all point to easing domestic inflation pressures. There is simply no reason for the Bank of England to raise interest rates given the weakness in labour market data. Risks are asymmetric; although the economy has been more resilient than may have been expected, risks to growth are skewed to the downside more than they the inflation risks are to the upside.
3. Underlying inflation pressures remain contained. While headline CPI has risen because of fuel and energy effects, core inflation and services inflation have remained relatively stable. August CPI rose to 3.1% from 2.9%, driven largely by fuel costs. Services inflation and core inflation, usually better gauges of underlying inflation, were unchanged at 3.4% and 2.6% respectively. Policymakers should focus on these underlying measures rather than react to energy-driven increases in headline inflation. A rate hike won't rustle up some barrels of oil. The situation for the UK is very different from the US, where a strong economy underpins the reason to hike.
4. The BoE can afford to wait. Since inflation is not broadening the MPC still has time to assess whether energy shocks create second-round inflation effects. So far, Governor Andrew Bailey's observation of subdued second-round effects supports the case for patience rather than another hike. The BoE's own inflation expectations survey showed a drop in year-ahead inflation expectation, albeit partly this was down to changing provider it would seem. And its Decision Maker Panel survey points to limited pass-through. DMP expectations for year-ahead CPI inflation fell to 3.1% in the three months to August, down from 3.4% in the three months to July. Firms' realised annual own-price growth was 3.7% in the three months to August, 0.1 percentage points lower than firms reported in the three months to July. Looking at today's statement, the BoE says the indirect impact of higher energy prices through firms’ supply chains onto CPI inflation was judged to have been small to date, and less than expected at the start of the conflict. This was particularly evident in weaker-than-expected food price inflation. While the BoE thinks it is possible that indirect effects from energy on CPI inflation had just been delayed rather than diminished, and those effects were expected to increase over the coming months, the degree and timing would depend on the extent to which firms could pass through energy costs in the current demand environment.
5. Markets are mispriced. The market is still pricing more inflation persistence and rate-hike risk than the economic data justify. Given the softer labour market, slower wage growth and absence of entrenched inflation pressures, I still expect the BoE to remain on hold for the rest of the year. Sterling should weaken and is could reprice to $1.30 as long as markets buy into Fed credibility and start to reprice UK rate cycle down. Note for example the BoE says nearly all respondents to the September Market Participants Survey (MaPS), which had closed on 4 September, not only expected interest rates to remain unchanged at this meeting, but also for a prolonged period thereafter. By contrast, the UK short-term interest rate curve was upward sloping and had risen further since the MaPS response window had closed, peaking at around 4.9% by end-2027.
Notably, the overhaul of the QT programme will see it pause all gilt sales until April 2027 while it consults with the government on selling gilts direct to the Debt Management Office at market prices, instead of holding its own auctions, which could further ease some of the upwards pressure on yields. It's having "robust" discussions with government still on this - seems they cannot yet agree. But it's also stopped selling ultra-long gilts, keeping around £120 billion of bonds that mature in 2049 or later on its balance sheet, whilst unwinding shorter maturities. After facing a lot of criticism for its active gilt sales, which made it an outlier among central banks in terms of executing QT, it looks like the BoE is finding ways to reduce pressure on the long end without abandoning the policy altogether. Members of the Monetary Policy Committee may be mindful of the 20-40bps impact QT has on long-end yields. Note also that we've just entered the OBR's forecasting period for the Budget, so the Chancellor will be thankful for rates to fall. The showed up at the long end with 30yr yields down 11-12bps on what amounts to a BoE version of the Fed's 'Operation Twist'. The decision to pause all gilt sales until April may also reflect the Bank is worried about volatility around the ongoing Iran war and US midterms.
GBPUSD broke down further to make new lows since 30 July to test old support/resistance level at 1.3360 with sterling offered on a dovish reading from the statement, while gilt yields were lower with the 10yr backing off about 8bps. There has been a slightly dovish read from this one with markets pricing out some of the aggressive tightening that had been seen in the curve. Why? Well apart from the measures to adjust gilt sales (which may be less material in their effect than the signal it sends), the doves continue to hold sway and none was persuaded to turn hawk. However, it does look like governor Andrew Bailey and rate setter Clare Lombardelli are moving closer to a hike in November, which would tilt things in favour of a November hike. If the conflict continues “the case for raising Bank Rate is building” (Lombardelli) and “it is likely policy may have to tighten” (Bailey). Similarly, Dave Ramsden said were "upside pressures on the inflation outlook to continue to build, there could be a case for increasing bank rate”. Sarah Breeden noted that if inflation risks crystallise it would be “increasingly appropriate for Bank Rate to respond”.
Wait and see remains the order of today but things can change. The BoE says there has been "little evidence" of material second-round effects in price and wage-setting, but the risks to the inflation outlook "are tilted to the upside, and more so than at the time of the July Monetary Policy Report".
The decision to hold rates is entirely consistent with its recent messaging. It's also consistent with inflation so far remaining entirely a supply shock story. Inflation is elevated but not alarmingly so, growth is mediocre, and the economy does not resemble the overheating conditions of 2022. The hurdle for another rate hike remains high, which means markets still appear to be pricing too much tightening risk and too little probability that the next move is ultimately lower rather than higher. Nevertheless, the BoE warned that inflation would hit 4% early next year and that policy would have to tighten "if the conflict in the Middle East persists for an extended period, as appears to be the case, and the risk of second-round effects emerging increases".
Reasons to hold
1. This is not a repeat of 2022. Higher inflation is being driven mainly by energy and fuel costs rather than a broad-based resurgence in domestic inflation. Unlike 2022, there is little evidence of a wage-price spiral, excess demand, or the post-pandemic labour market distortions that previously worried policymakers. This is not 2022 - the labour market is in a far worse place, workers lack the bargaining power they had then, rates are already restrictive and not at the zero lower bound, and we don't have the huge post-pandemic demand impulse that unleashed prices and inflation expectations became unanchored.
2. The labour market is cooling. The UK labour market has softened materially. Rising unemployment, falling vacancies and slower wage growth all point to easing domestic inflation pressures. There is simply no reason for the Bank of England to raise interest rates given the weakness in labour market data. Risks are asymmetric; although the economy has been more resilient than may have been expected, risks to growth are skewed to the downside more than they the inflation risks are to the upside.
3. Underlying inflation pressures remain contained. While headline CPI has risen because of fuel and energy effects, core inflation and services inflation have remained relatively stable. August CPI rose to 3.1% from 2.9%, driven largely by fuel costs. Services inflation and core inflation, usually better gauges of underlying inflation, were unchanged at 3.4% and 2.6% respectively. Policymakers should focus on these underlying measures rather than react to energy-driven increases in headline inflation. A rate hike won't rustle up some barrels of oil. The situation for the UK is very different from the US, where a strong economy underpins the reason to hike.
4. The BoE can afford to wait. Since inflation is not broadening the MPC still has time to assess whether energy shocks create second-round inflation effects. So far, Governor Andrew Bailey's observation of subdued second-round effects supports the case for patience rather than another hike. The BoE's own inflation expectations survey showed a drop in year-ahead inflation expectation, albeit partly this was down to changing provider it would seem. And its Decision Maker Panel survey points to limited pass-through. DMP expectations for year-ahead CPI inflation fell to 3.1% in the three months to August, down from 3.4% in the three months to July. Firms' realised annual own-price growth was 3.7% in the three months to August, 0.1 percentage points lower than firms reported in the three months to July. Looking at today's statement, the BoE says the indirect impact of higher energy prices through firms’ supply chains onto CPI inflation was judged to have been small to date, and less than expected at the start of the conflict. This was particularly evident in weaker-than-expected food price inflation. While the BoE thinks it is possible that indirect effects from energy on CPI inflation had just been delayed rather than diminished, and those effects were expected to increase over the coming months, the degree and timing would depend on the extent to which firms could pass through energy costs in the current demand environment.
5. Markets are mispriced. The market is still pricing more inflation persistence and rate-hike risk than the economic data justify. Given the softer labour market, slower wage growth and absence of entrenched inflation pressures, I still expect the BoE to remain on hold for the rest of the year. Sterling should weaken and is could reprice to $1.30 as long as markets buy into Fed credibility and start to reprice UK rate cycle down. Note for example the BoE says nearly all respondents to the September Market Participants Survey (MaPS), which had closed on 4 September, not only expected interest rates to remain unchanged at this meeting, but also for a prolonged period thereafter. By contrast, the UK short-term interest rate curve was upward sloping and had risen further since the MaPS response window had closed, peaking at around 4.9% by end-2027.
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