BOE Preview: Better Safe Than Sorry

Summary:

• We BOE is expected to keep the Bank Rate unchanged at 5.25% due to the need for potential upward revisions in macroeconomic projections, with service inflation and wage growth remaining well above target.
• Vote split considerations: The two votes for a rate cut and hold votes from June's BOE meeting are unlikely to change. Additionally, four MPC members are unlikely to switch from hold to cut due to potential upward revisions in growth projections for the year.
• Increased borrowing requirement to cover the fiscal gap is a key focus. With future tax hikes uncertain in timing and scale, the BOE risks exacerbating inflationary pressures and undermining financial stability if it eases monetary policy prematurely.
• If the BOE holds rates at this week’s meeting, it is likely that the yield curve will slow its steepening. Two-year yields may soar to test resistance at 4% and remain range-bound until the central bank actually begins cutting rates. Long-term yields remain at risk of rising if the BOE sounds too dovish.

BOE Monetary Policy Decision Outlook

Markets are pricing in a 50:50 chance of a rate cut this week, with SONIA futures indicating expectations for nearly three rate cuts by the end of the year. Despite valid arguments for both outcomes, we expect the BOE to keep the Bank Rate unchanged at 5.25%, as a new set of macroeconomic projections might need revise growth upwards for the year and service inflation and wage growth remains well above target.

Vote Split Considerations

At the BOE's June meeting, the vote split was 7-2 in favor of holding rates. Since then, policymakers have remained largely silent on monetary policy due to the recent UK general elections, providing little insight into this month's vote result. While Dhingra and Ramsden are expected to continue voting for a rate cut, the key question is whether three more members will join them. Haskel and Mann are unlikely to support a cut, with Mann citing inflation risks due to a "tight and impaired labor market" and Haskel noting that the 2% CPI print might be temporary. Additionally, Clare Lombardelli is succeeding Ben Broadbent at this meeting, and it is improbable that she will vote for a rate cut in her first meeting. While it is possible that the remaining four members might tilt dovish, we believe they will remain cautious at this meeting due to potential upward revisions in growth projections and the considerable fiscal gap recently announced by the Treasury.

Ample Reasons for Policymakers to Remain Cautious

• Growth Exceeding Expectations: Annualized GDP growth for the first quarter has risen to 0.7%, the highest since the fourth quarter of 2021. This increase is supported by recovering real wages, which are contributing positively to growth. In its May monetary policy forecasts, the Bank of England expected GDP to have risen by 0.4% in the first quarter and projected an annualized growth rate of 0.2% for the second quarter. An upward revision to these projections is likely, as wage growth remains at 5.7% year-over-year, giving policymakers reason for caution.

• Stubborn Services Inflation: Services inflation remains persistently high, having risen 5.7% year-over-year in June. While the UK's goods CPI dropped by 1.4%, it is uncertain whether this decline will continue. However, given the season, the underlying momentum remains strong, indicating that headline inflation is likely to exceed 2% throughout the year and remain persistently high. This situation calls for a cautious monetary policy stance.

• Increased Borrowing to Cover Fiscal Gap: The recent Treasury audit into public finances showed a significant fiscal gap, estimated at £21.9 billion for the current fiscal year. This shortfall is primarily due to pressing needs in various departments and public sector pay rises. To address this, Chancellor of the Exchequer Rachel Reeves plans to fund a fraction through savings and the remainder through increased borrowing. The BOE might be wary of cutting interest rates too early because this increased borrowing could stimulate economic activity, leading to higher inflation. With future tax hikes uncertain in timing and scale, the BOE faces the risk of exacerbating inflationary pressures and undermining financial stability if it eases monetary policy prematurely.

BOE Rate Decision and Yield Curve Implications

The UK yield curve has recently disinverted, with 10-year Gilts currently yielding 15 basis points more than 2-year Gilts. The rally in 2-year Gilts is noteworthy, as yields fell from 4.55% to 3.85%, shedding 70 basis points in three months. Currently, the spread between the BOE base rate of 5.25% and 2-year yields is around 140 basis points, reflecting expectations of an upcoming aggressive interest rate-cutting cycle.

If the BOE holds rates at this week’s meeting, it is likely that the yield curve will slow down its steepening, with 2-year yields likely to soar to test resistance at 4% and remain range-bound until the central bank actually begins cutting rates. While further steepening of the yield curve is expected in the second half of the year, the direction of long-term rates remains uncertain. This year’s fiscal spending is likely to be financed by borrowing; however, in an attempt to boost government revenues in the long term, politicians might engage in economic growth initiatives that would lead to higher tax revenues, thereby creating a floor for 10-year Gilt yields. If the BOE cuts rates within this environment and amid these uncertainties, markets might fear a reacceleration of inflation in the long term, which would push long-term yields higher.

Investment Strategy

Overall, we see scope to continue limiting portfolio duration and favor the short part of the yield curve. Assuming a one-year holding period, 2-year Gilt yields (GB00BL68HJ26) would need to soar above 12% to incur a loss, whereas the yield on 10-year Gilts (GB00BLPK7334) would need to rise by 70 basis points to enter the red.