Bank of England sets market up for shallow hikes

In what looks to be a now characteristic pattern, the Bank of England hiked rates then immediately talked down the tightening impact. The BoE hiked the Bank Rate by 75bps, taking it to 3% and implementing the largest hike since 1992. As far as hawkishness, that was about all markets got as every other element of this week’s MPC decision tilted decidedly dovish, even as the UK endures inflation at 10%. Unlike the Federal Reserve’s apparent unanimity in tightening policy, the BoE vote was still split, with seven of nine members voting for the 75bps hike, one wanting a 50bps and one member supporting a 25bps hike. Additionally, the MPC outlined a prolonged recession starting from Q3 2022 and extending into all of next year and into 2024 as well. Even if the BoE held rates at the current level of 3%, the MPC still outlined a recession for 2023.

Governor Andrew Bailey also squashed market expectations for a sustained move higher in rates, saying that rates “will have to go up by less” than what markets were expecting, otherwise the negative impact on the UK economy would be too severe.

The BoE’s turn at hiking 75bps showed a very different central bank message than the Fed earlier in the week where support for the move was unanimous and the tone is still very much on destroying inflation, even at the expense of economic activity. Markets had already been adjusting their trajectory for UK rates lower after the fiscal and financial chaos of the Truss administration seems to have been alleviated by the combination of prime minister Rishi Sunak and chancellor Jeremy Hunt. One-year swaps beginning one-year ahead (1Y1Y) have moved from a peak of 6.3% in late September to 4.6% at present. As far as policy rates are concerned, markets still expect to see rates going higher into 2023 although peaking at around 4.6%, slightly lower than their pre-MPC expectation.

Swaps market adjusting to lower UK rates trajectory

Source: Bloomberg, Emirates NBD Research

The BoE dovish hike comes ahead of the UK government’s new fiscal plan, due out in a few weeks. A sharp drop in government spending is likely to be outlined which may help on the inflation front but could also lead to a further drag on growth. That will probably force the BoE to decelerate its pace of hikes going forward; markets are currently split between a 50bps and 75bps hike at the December MPC.

In response to the hike that wasn’t, GBPUSD sold off by 2%, its largest decline since the release of the Truss administration mini-budget in mid-September. It has recovered a little in trading post-MPC to hold near the 1.12 level. But with the government set to outline further tightening in fiscal policy and the BoE not likely to move as much as markets had been expecting, the negative outlook for GBPUSD still looks to remain in place. Those same 1Y1Y swaps for sterling have moved from a decent premium over similar maturity USD-swaps—sparked by the apparent need for the BoE to hike by as much as 100bps following the Truss administration—to now a modest discount compared with USD swaps. With the Fed likely to slow its hikes but still move forward with them, and crucially maintain a hawkish tonality, we expect that risks for GBPUSD still remain on the downside.