Kindness of Strangers Lifts Pound But Economists See The Bank of England Backed Into A Corner

Never before has the case for action been so weak at the beginning of a hiking cycle, and markets so certain that policymakers will move, which has prompted economists to question what happens next. 

The Pound continued to rise Tuesday as fears over the current state of Brexit negotiations receded further in the wake of October’s European Council summit which saw European politicians sound a more conciliatory tone on the subject of talks.

Even if they didn’t really budge on their position of “insufficient progress”, the less confrontational tone of leaders has buoyed the Pound into the new week with traders taking heart from pledges to begin “internal preparations” for trade and transition talks.

But with much of Sterling’s new found stability against the G10 basket contingent upon a rate hike narrative that has come under increasing scrutiny in recent weeks, it remains to be seen how much longer it can last for.

The Bank of England has backed itself up against a wall with September’s interest rate warning, according to one economist, who says a November rate hike is necessary for the sake of the BoE’s credibility but the wrong move for the economy. 

Never before in the BoE’s history as an independent central bank has the case for action been so weak at the beginning of a hiking cycle, and markets so certain that policymakers will move.

“We expect a BoE rate hike on 2 Nov. because of what rate setters have said, not what the data have done,” says Robert Wood, chief UK economist at Bank of America Merrill Lynch.

The Monetary Policy Committee at the Bank of England said in September that it could withdraw stimulus from the market (hike rates) over the coming months if inflation continued to march north of its 2% target and the economy remained on an even keel.

“We only reluctantly changed our call from them staying on hold after several rate setters doubled down on their September guidance that a hike was coming,” says Wood.

Market prices of UK government bonds now imply more than an 80% chance of an interest rate hike in November while Wood says it would take a third-quarter GDP reading of 0.0% or worse to prevent the Bank of England from pulling the trigger.

Sterling has risen from the depths of its August lows in response to the evolution of market expectations around rates, posting a year to date gain over the US Dollar and halving its 2017 loss against a resurgent Euro to around 4.5%.

“Inflation has peaked we think and will drop below 2% next year,” says Wood. “We think the BoE inflation forecast is well off beam given fading pipeline inflation pressures.”

UK wage growth is currently trending at around 2% per year and, according to Wood, this is insufficient to deliver 2% underlying inflation on a sustainable basis.

In addition, retail sales growth is showing signs of stalling, with volumes the weakest in four years, while labour market gains have also slowed. But markets are still pricing a hike in November and more to come once into 2018.

“Tenreyro mentioned this in her testimony: if the BoE get it wrong they may need to cut more in the future than they would otherwise have done. It may be safer to wait and see. That would be our view too for what it's worth,” says Wood.

In among the recent economic statistics, and the market implied predictions for interest rates in November and beyond, is a recipe for an accelerated economic slowdown that merely backs the Bank of England into another corner.

This corner will have the same above target inflation and slowing economy on the one side of it and plenty of damaged credibility on the other.

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MPC Is Divided But Majority May Still Hike

Traders are nearly unanimous in their expectation of a November rate hike. But the Bank of England’s panel of interest rate setters, the Monetary Policy Committee, is not nearly as unified.

“Jon Cunliffe's recent comments suggesting he would not support a November hike have put the cat among the pigeons. We assume no hike is perhaps a 25% probability event, but it's hard to know,” says Wood. “Mark Carney and the MPC could have been leading us on a merry dance here.”

All of the indications are that a simple majority will vote for a rate hike in November, although there could be a number of dissenters, which isn’t a good thing for Sterling.

“Based on their testimony to MPs this week, David Ramsden and Silvana Tenreyro seemed to us more likely than not to call for no change in policy in November,” says Wood. “Jon Cunliffe's recent comments on BBC Wales suggested he would not support a hike in November.”

This means three of the nine voters on the MPC may depart from the herd and vote against a rate hike. Andy Haldane and Ben Broadbent are both internal members of the MPC and so, according to Wood, are likely to vote with governor Mark Carney for a hike.

Michael Saunders and Ian McCafferty’s hawkish views, favouring higher rates, are well known and so it is probably safe to say these two are quite likely to vote for a hike. Gertjan Vlieghe, who has historically opposed a tightening of policy, dropped his opposition in September and suggested he might back a rate rise too.

“This leaves us expecting a 6-3 vote, though we are more than usually uncertain about that. It could be a 5-4,” says Wood. “The vote will matter for how we interpret the Inflation Report.”

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November or December?

A narrow majority of the MPC may seem likely to support a hike in November but, with recent data taken into account, at least one strategist is suggesting the Bank of England will kick the can down the road.

“Inflation as measured by the consumer price report is on the rise but as some U.K. policymakers including Governor Carney pointed out this past month, CPI could have peaked in October,” says Kathy Lien, a managing director of foreign exchange strategy at BK Asset Management in New York City.

Lien notes the recent pickup in wage growth in the UK and forecasts that rising pay levels will eventually mean a recovery in consumer spending and a consequent pickup in underlying inflation pressures. But she also flags uncertainty over when this is likely to happen.

“Investors may be pricing in a rate hike in November but based on the big drop in retail sales last month, they may delay the move to December,” she warns.

Meanwhile, with no major economic reports due from the UK in the week ahead, and policymakers set to remain silent, the Pound’s fate will be determined by Brexit headlines, the direction of the US Dollar and the European Central Bank’s eagerly anticipated monetary policy announcement.

“On a technical basis, GBP/USD has found support at the 50-day Simple Moving Average, so if there's a place for a reversal, it would be off those levels,” says Lien.

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