Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Bank of England preview: an unconvincing pause is in the cards.
Althea Spinozzi
Head of Fixed Income Strategy
Summary: The BOE is on the verge of losing its credibility as it tightened the economy too little, too slowly. At this week's MPC meeting, Bailey will need to hide behind the higher-for-longer message as inflation is becoming more entrenched, but policymakers keep interest rates on hold as they worry about the economy. UK Gilts are poised to align with the prevailing global direction or rising yields, with 10-year Gilts resuming their rise towards 5%.
At the September monetary policy meeting, the Bank of England opted to keep rates on hold, with five members out of nine voting for a pause. Over the past six weeks, the market received little UK data for the BOE members to change their stance. Yet, September’s inflation numbers showed that core CPI rose by 0.5% MoM and 6.1% YoY, slightly above expectations.
Therefore, it is reasonable to expect those members that have voted for a hike last month to vote for the same this week. The only significant exception is Jon Cunliffe, who previously voted for a hike, left. Sarah Breeden takes his place, voting for the first time at this week’s MPC meeting. Her vote might be decisive. Yet, there is a high probability that at her first MPC meeting, Sarah will not vote against consensus, resulting in a 6-9 split in favor of a pause.
Still, the central bank cannot afford to lean dovish. UK inflation remains the highest among developed economies. At the same time, the labor market is tight, and the country depends on energy and goods imports. With upcoming elections in January next year, fiscal policies remain uncertain as Rishi Sunak is losing popularity, adding to inflation upside risk.
Within this environment, the BOE is on the verge of losing its credibility. It tightened the economy too little, too slowly. There is no option for Bailey other than sticking to the higher-for-longer rhetoric, hoping to maintain a hawkish bias while it's becoming more apparent that policymakers are afraid of breaking something. As high inflation becomes entrenched in the economy, the sterling will come under pressure.
The 3-month SONIA curve shows the BOE beginning to cut interest rates in September next year, a quarter after the ECB and the Federal Reserve. Bond futures expect the central bank to cut rates only twice in 2024 compared to three times in the US and Europe. Rates are also expected to never drop below 4.20% until 2029, leaving long-term Gilt vulnerable to a bear’ steepening of the Gilt yield curve, similar to what we have seen in the US.
Within this context, it’s hard to envision a Gilt rally. Ten-year Gilt yields are still likely to rise to 5% as inflation becomes more entrenched.
10-year gilts seem range bound between 4.20 and 4.75. However, within that range Gilts are in a slightly rising trend but need to break above 4.75 for further upside.
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