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“Great Expectations” of Base Rate Rises?

22 September 2017 by Chris Bowie

Last week was a pivotal week for UK base rate expectations. First, we had a stronger than expected UK CPI and RPI print, subsequently echoed by a stronger than expected US CPI print. UK CPI is now 2.9%, just 10bp lower than the “see me after class” missive that Mark Carney might need to write to the Chancellor. For anyone who thinks in old money terms, RPI is now 3.9% and RPIX (RPI excluding mortgage interest payments) is 4.1%.

Then we had the MPC. Whilst rates were kept unchanged, the tone of the meeting was hawkish and the committee warned the markets that they were not pricing in enough rates risk, and further, that the majority of the members thought it would be appropriate to increase rates over the coming months.

The combination of stronger inflation and more hawkish central bank talk has certainly impacted the currency and bond markets, with cable rallying from its low in August of 1.2774 to 1.3580. Similarly, 10Yr gilts have seen yields rise from 0.951% to 1.368%, with the gilt market being down -3.76% in value terms over the last two weeks alone, taking YTD returns to -0.31%. Quite a move. The front end of the curve has been affected too, with 6m gilt yields +12bp, 1Yr +25bp, 2Yr +28bp, 5Yr +36bp and 10Yr +42bp (the biggest yield move across the whole curve).

So where does this take us in terms of base rate expectations for the remainder of this year and into 2018?

Looking at base rate expectations on Bloomberg, the probability of a 25bp hike at the next MPC meeting on 2nd November 2017 has risen from less than 20% to 67% in the space of two weeks, with the market pricing no probability of a 50bp hike by then. Moving to the end of the year, the probability has risen to 75% that we will have at least one hike by the 14th December, but here the market is starting to price in the small chance of a 50bp hike by that time (although by far the greatest probability is still for just one 25bp hike in total). Moving out the expectations curve to a year from now to September 2018, the market is pricing in a 94% probability of at least one hike, but with a more balanced spread of possibilities between one hike and three hikes over that period.

Our own view is that one hike in the near term is quite likely. The MPC can easily justify this on the grounds of taking back the emergency cut that followed the Brexit vote in June last year. That was an insurance policy that was warranted at the time, but given employment and factory orders have held up very well since then, perhaps it is no longer justified. Beyond that, we expect the MPC to wait and see. Why? Well, inflation has certainly risen, but still appears transitory given the weakness in the pound which has certainly imported inflation, set against risks relating to Brexit. Real wage growth still appears lacklustre, and until/if the wage round picks up a gear we would not be more concerned about domestically generated inflation – but we must be cognisant of risks. Therefore, we think the risks of further base rates rises in 2018 looks small at this point, but we will need to keep a close eye on the data for signs of any domestic inflation. The front end of the yield curve should remain well behaved in this case.

We are still bearish on gilts and duration overall (see Mark’s blog from Tuesday), but do we have great expectations of future base rate rises? In short, no. In a slight nod to Dickens’s novel, the events of the last two weeks have shown that we cannot expect the MPC to be a laissez-faire benefactor to the gilt market any longer. Instead, the reality of having to judge base rate adjustments driven by inflation and output data returns to the fore, and the gilt market will have to stand on its own two feet without extra stimulus from Q.E. purchases, nor a dovish central bank.

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