27 July 2018
Different this time
Over the last year we have commented several times on the actions (or inaction) of the BoE, having been firmly of the view that this will prove to be a very shallow interest rate hiking cycle compared to what we have seen in the past. We even suggested the rate rise in November 2017 could be ‘one and done’ for the next 12 months - a notion that has been tested more than once of late!
For instance, market expectations had gravitated towards an interest rate hike in May, with an assigned probability of over 90 per cent, only for UK economic data to soften and rate rise expectations to collapse. And so, here we are again, with the probability of an August UK rate hike registering at around 90 per cent. Yet this time, we expect the BoE to stand and deliver only their second interest rate rise in the past ten years.
Source. Thomson Reuters Datastream, Fidelity International, July 2018
Why is this time any different? From a credibility perspective, having prematurely raised market expectations on more than one occasion, the BoE may well believe they now have to deliver a rate rise in August. Moreover, the argument put forward by the BoE is relatively consistent - a strident belief that the UK economy is growing above its meagre trend growth and that inflation is likely to pick-up as a result.
The latest rebound in GDP data is seen as sufficient justification for MPC members to believe the first quarter slowdown was merely a blip. The new monthly GDP series also suggests the UK economy is growing at 0.3–0.4 per cent quarter-on-quarter - though still quite paltry within a historical context and possibly influenced on the consumer side by one-off factors, such as the royal wedding, the football world cup and the extraordinarily warm weather.
Is a rate hike the right thing to do? While a recent pick-up in growth fits in with the BoE’s broader narrative of a previous weather-related slowdown, the other pillar of the BoE’s reasoning was that inflation would continue on a steady footing (following the currency related rise) and wages would pick up due to tighter labour market conditions.
However, not only has inflation surprised to the downside, but it is also within a whisker of the 2 per cent target - with core CPI at its weakest level since March 2017. Wage growth also remains stubbornly subdued, with little sign of the pressure easing on UK households in the near-term. Mindful of the global and domestic macro and political backdrop (namely ongoing UK government instability), I continue to believe that a prospective rate hike is an unnecessary risk.
Source: Thomson Reuters Datastream, Fidelity International, July 2018
Intriguingly, since the case for a rate rise was touted in March, UK 10-year gilt yields have moved closer to their lows for the year (circa 1.3 per cent at present). Market participants are rightly looking beyond August’s meeting and perhaps now echo our views that the prospect for further rate increases is gradual at best, with any hikes likely to be accompanied by a dovish tone.
That said, the fall in UK gilt yields chimes with the broader global trend we have seen in the last few months. In the US, 10-year treasury yields have fallen from their peak in May to below 3 per cent again. The reason for this, and why I believe we have seen the peak in yields for this year, is the moderation of the ‘synchronised growth’ theme. Should late cycle concerns intensify after the summer lull, investors may well be questioning the prospect of further rate hikes before the turn of the year (not just in the UK, but also in the US).
While it always proves something of a challenge to finesse the timing, our preference of late has been towards higher duration and a more defensive credit beta. After all, the latter is going to be just as important if a rise in market fragility materialises in the second half of the year.
As for the here and now, investors will just have to watch and see whether the BoE can stand and deliver.
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