Is it one and done at the Bank of England this week?

On Thursday the Bank of England will announce its latest interest rate decision, it will also release its Inflation Report all at 1200 GMT, before Governor Mark Carney speaks at 1230 GMT. The market is fully expecting an increase in the UK’s interest rate to 0.5% at this meeting, expectations are high with the UK’s Overnight Index Swaps market pricing in an 88% chance of a hike on Thursday.

On Thursday the Bank of England will announce its latest interest rate decision, it will also release its Inflation Report all at 1200 GMT, before Governor Mark Carney speaks at 1230 GMT. The market is fully expecting an increase in the UK’s interest rate to 0.5% at this meeting, expectations are high with the UK’s Overnight Index Swaps market pricing in an 88% chance of a hike on Thursday.
 
Will the unreliable boyfriend be tamed once and for all?
 
Although a hike cannot be guaranteed - Mark Carney is famously referred to as the unreliable boyfriend - it is highly likely that the Bank will hike rates otherwise its credibility could be on the line. The Bank has been preparing the markets for this hike for some time, so if they don’t pull the trigger it is likely to cause a wave of volatility in UK asset prices, and in the pound and gilt markets in particular.
 
This does not mean that Thursday’s decision will be an easy one for the members of the MPC. They have a conflict of objectives, with compelling reasons to both hike rates and remain on hold, which we list below:
 
 
Reasons to remain on hold:
·      The Phillips curve is disappearing. The theory suggests that when the unemployment rate falls then wages should rise. However, this has not been the case and the curve is basically flat since 2015, as you can see in the chart below.
·      Risks to economic growth including Brexit and low wages.
·      Due to the prevalence of variable rate mortgages in the UK, the impact of a rate hike can be transmitted very quickly to households, which are already highly indebted.
 
Reasons to hike include:
·      Inflation is well above target at 3%.
·      The unemployment rate is at its lowest level since 1975.
·      Q3 growth surprised on the upside, and if inflation falls in 2018 as expected then we could see growth pick up.
·      Brexit negotiations, although they remain a key risk to economic growth there are signs that things are moving in the right direction. The government now wants the transition phase agreed by the end of Q1 2018, which would take the pressure off of finding a resolution to everything by March 2019. Also, some large banks such as UBS have suggested that the regulatory landscape post Brexit is sufficiently transparent at this stage that they won’t be moving 20% of their workforce out of London, which could ease fears about mass job losses after Brexit.
 
This is no easy decision for the BOE, especially the impact a rate hike could have on the budgets of variable rate mortgage holders. However, there is a solution that could make this pill easier to swallow. The BOE could swaddle this rate hike with a comforting message that there will be no prolonged rate hiking cycle, essentially the bank is “one and done” when it comes to hiking rates. This could be reinforced in the markets if there are some dissenters on Thursday who vote to keep rates on hold. If there is only a slim majority in favour of hiking rates then we could see the market push back expectations of a second rate rise until 2019.  
 
The BOE’s inflation and GDP forecasts will also be worth watching at this meeting as sharply falling inflation alongside weak growth expectations for the next 12 months’ could boost market expectations that this hike really is an isolated move.
 
Our base case
 
We believe that the most likely scenario on Thursday is that the BOE does hike interest rates in a bid to reverse the cautionary cut to rates after last year’s referendum vote in favour of Brexit. The economic mauling that was expected after the vote has not come to pass, which makes it appropriate to reverse the cut at this stage.
 
The market reaction: sterling’s rally cut short
 
If this is the case then we believe that the recent rally in the pound could be short-lived.  Sterling has benefitted from a falling dollar and an ECB-induced weaker euro this week, as well as expectations of a rate rise from the BOE. GBP/USD is rallying into this BOE meeting and is currently testing the $1.33 mark, however we think that this could be a “buy the rumour, sell the fact” scenario, and the pound could be at risk from a sell-off if the BOE signals that no further rate hikes are waiting in the wings. This could boost Gilts (weigh on yields), and it may also boost the FTSE 100 and 250, which both have a decent inverse correlation to sterling.

Chart 1: the UK’s disappearing Phillips Curve

Source: City Index and Bloomberg 


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