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Brexit Battle Brewing for the Bank

23 October 2019 by Ben Hayward

In the current environment, with several large risk drivers bubbling away, it is often hard to see exactly what outcomes the markets are pricing in. The same cannot be said of the recent positive developments on Brexit, which have had a very clear impact on some markets –sterling has rallied from 1.08 to around 1.16 (GBP/EUR), and 10-year Gilts have fallen by three points.

Boris Johnson’s government may have been defeated on the short timeframe it proposed for getting his new deal through parliament on Tuesday night, but his Withdrawal Agreement Bill did pass its second reading (after which a raft of amendments can be proposed by opposition parties), which is the first time since the referendum in 2016 that parliament has returned a positive result on any Brexit deal. There is a long way to go, but markets appear much more confident that a ‘no-deal’ exit will be avoided.

Interestingly, however, we have not seen this impact UK interest rate forwards; Bloomberg currently shows a <1% expectation of a rate hike out to September 2020, but with the probability of a cut varying from 10% to 50% over the same period. It is a bit of a surprise to us to see fixed rates hurting and Libor ticking up a bit, but with no bank rate rises being priced in.

What makes this all the more curious is that the Bank of England governor, Mark Carney, has been clear that the outlook for the UK will depend on how “hard” the Brexit withdrawal is, and that “the appropriate path of monetary policy will depend on the balance of its effects”. Carney has consistently suggested that if not for Brexit, the performance of the UK economy would have justified rate rises by now, and the strong implication has been that he would like to have those rate rises done to give the BoE the ammunition to ease monetary policy as the cycle turns and growth drops off. Surely then in an environment where a hard Brexit is looking a relatively remote possibility, the market should regard rate rises as a likely outcome, all else being equal?

Not only has the UK economy shown resilience in the face of the Brexit uncertainty, but the assumption is that we would see a mini-boom funded by the investment that has been kept on the side-lines while Brexit has played out.

When reading the opening remarks from the BoE’s press conference in August, it is apparent how low expectations were for any resolution, let alone a soft resolution. However, the Bank did predict that a smooth transition would mean a recovery in business investment and household spending, and with a current environment of materially easier financial conditions, even stronger acceleration in growth with CPI inflation “well above target” and still rising. This would lead to a scenario where gradual rate rises should be expected.

Since those August remarks, however, we have seen a further slowing in the global economy. Does this provide a counterweight to the Brexit “relief” stimulus, and will it convince the BoE to keep rates at the current level? We were learning this time last year that investors disagreed with the Fed about its future rates direction, and clearly the market won that argument. Is there another disagreement brewing on UK rates?

The BoE’s next press conference is in two weeks, and there is now potential for a Brexit deal to be done by then. If so, the guidance may well be that policymakers are waiting to see if the positive effects of the Brexit resolution help the UK escape from the global slowdown, but any shift in their focus from Brexit to global growth risks would be of significant interest.

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