Bank of England Preview: Rates on Hold, but Inflation and QT Shape the Outlook

Summary:

• BoE to Hold Rates: The Bank of England is expected to keep rates steady in September, reflecting a cautious approach due to persistent inflation, especially in services, and elevated wage growth.
• Quantitative Tightening (QT): The BoE is likely to announce a further £100 billion reduction in gilt holdings in the next twelve months, reducing the need for active sales, which could provide fiscal relief for the government in light of the Autumn Statement.
• Market Expectations: Markets anticipate two BoE rate cuts by year-end, but ongoing uncertainty around growth and inflation makes short-term gilts a more attractive and secure investment option compared to long-term gilts.

The Bank of England (BoE) is expected to hold interest rates steady at its September meeting, after cutting rates in August for the first time since 2020. Despite that rate cut, the BoE has continued to take a cautious approach, as emphasized by Governor Andrew Bailey at the Jackson Hole symposium. The upcoming meeting is likely to maintain this careful stance on easing policy.

Key Expectations:

• Rates on Hold: The BoE is likely to keep the base rate at 5%, signaling that it remains unconvinced inflation has been fully tamed. While inflation has cooled in recent months, services inflation remains a concern, expected to rebound to 5.6% in August, keeping inflationary pressures alive.
• Vote Split: We anticipate Swati Dhingra likely advocating for a 25-basis-point cut, while deputy Governor Dave Ramsden might vote with the majority this time. This week’s BoE meeting will mark Alan Taylor’s first as he steps in to replace Jonathan Haskel. While his policy stance remains unclear, we anticipate that Taylor will vote in line with the majority at his first meeting.

Inflation and Wages:

• Inflation Data: The latest Consumer Price Index (CPI) data, released a day before the meeting, is expected to show headline inflation steady at 2.2%, but core inflation could rebound to 3.6% due to the rise in services prices. Despite the slight cooling seen earlier in the year, persistent inflationary pressures remain a key concern for the BoE.
• Wage Growth: While wage growth has surprised to the downside, with the 3-month average weekly earnings at 4% (down from 4.5%), it remains significantly higher than pre-pandemic levels. This is keeping real disposable income elevated compared to the 2010-2020 average, adding to the inflationary backdrop.

No New Macroeconomic Projections:

No new forecasts or significant forward guidance are expected at this meeting. The BoE’s next major economic reassessment will come in November, when fresh forecasts could open the door for more aggressive rate cuts depending on inflation trends.

Quantitative Tightening (QT):

The Bank of England is expected to announce a further £100 billion reduction in its gilt holdings over the next twelve months as part of its ongoing quantitative tightening (QT) program. This reduction will occur through a mix of passive runoff, where maturing bonds are not replaced, and active gilt sales.

In the past year, the BoE has already trimmed its balance sheet by £100 billion, and the main question now is whether it will maintain the same target for the coming year. Should the central bank choose to stick to this plan, it would need to scale back active gilt sales from £50 billion to £13 billion per year, since £87 billion worth of gilts are set to mature over the next twelve months. This potential decrease in active sales could prove beneficial for Chancellor Rachel Reeves, as the UK government is responsible for covering any losses associated with the BoE’s bond sales. Reducing the volume of active sales could ease some of the financial burden on the government, providing Reeves with more room to maneuver when preparing the Autumn Statement.

Current Market Expectations:

Swap markets are currently pricing in two rate cuts by the BoE before the end of the year, with the first expected in November and the second in December. From November onward, markets anticipate the BoE will cut rates at each subsequent meeting until June 2025, eventually bringing the benchmark rate down to 3.5%.

The broader economic outlook suggests moderate growth, with the UK economy expected to expand at a real growth rate of 1.1% this year. Meanwhile, inflation is projected to end the year with headline CPI at 2.6%, indicating a slight rebound from current levels but still close to the BoE's target. This economic environment, characterized by stable growth and moderating inflation, supports the expectation of a gradual easing cycle, although an acceleration of rate cuts depends on incoming data.

Expected Market Reaction:

Gilts have remained relatively stable to date, despite being influenced by broader global trends. While 10-year U.S. Treasury yields have declined by over 100 basis points since their April peak, 10-year gilt yields have only dropped by 64 basis points, suggesting that markets are pricing in fewer rate cuts in the UK compared to the U.S. For UK yields to fall further, the Bank of England (BoE) would need to adopt a more dovish stance, signaling more easing than currently anticipated in swap markets.

At the upcoming BoE meeting, the gilt market is likely to be highly sensitive to inflation data. With inflation remaining elevated and showing signs of a rebound, it is unlikely that the BoE will embark on an aggressive rate-cutting cycle in the near term. In this context, extending duration remains a directional bet, heavily dependent on the BoE pursuing an aggressive easing cycle and on intensifying disinflation. However, at present, there is significant uncertainty around whether such scenario will materialize, making this strategy highly uncertain.

That's why we continue to favor short-term gilts. Despite the recent drop in 2-year gilt yields, currently sitting at 2.8%, they offer an attractive risk-reward profile. Yields would need to rise above 6.8% within a year before resulting in a loss. In comparison, 10-year gilts, now yielding 3.65%, would move into negative territory if yields rise above 4.15% over the next twelve months. Given that markets expect the benchmark rate to bottom at 3.25% in the coming years, it's plausible that 10-year gilt yields could surge above 4% again, making short-term gilts a more secure choice in the current environment.