Curb Your QE
A month ago, we wrote about the potential downside risks facing the gilt market. Since then, market pricing continues to play down these risks, but having witnessed a recent barrage of pressure on the Bank of England, we felt now is a good time to give an update on our expectations on their policy responses.
This week the market digested another high UK CPI print, with the release of June's data showing a 2.5% y-o-y jump. While the BoE continues to espouse their view that this inflation is transitory, we believe its magnitude and timing may introduce some doubt. 2.5% is yet again a breach of their stated 2% target. Furthermore, that above-target inflation is occurring relatively quickly in the UK's recovery (we have not even reached the July 19th Freedom Day yet) appears to dramatically increase the chances that the economy will breach the key 3% CPI level. When the BoE misses their inflation target by more than 1%, it must formally explain the cause to the Government. The most apparent hint that the BoE is concerned came from remarks from voting member Michael Saunders and Deputy Governor Dave Ramsden. Ramsden warned inflation might hit 4% this year and "conditions for considering tightening being met sooner than I had previously expected". Moreover, Saunders added, "the question of whether to curtail our current asset purchase programme early will be under consideration at our forthcoming meetings".
Meanwhile, the House of Lords Economic Affairs Committee has just concluded its report "Quantitative Easing: a dangerous addiction". The report posits that the BoE needs to be more open about its views on inflation and why QE is still the correct policy response. The authors also claim that the BoE has failed to justify its use of QE. While much of the Lords' enquiry appears to be political posturing, our view is that QE will become a less critical policy tool than it has been in recent years. QE applied particularly well to the conditions prevalent during the financial crisis. It injected stimulus into an economy struggling because of a liquidity crisis and had the valuable side effect of supporting a banking system grappling with low levels of capital, while reducing punitive borrowing costs for corporates. While QE led to asset price inflation, this was at least from a depressed starting point. So what is different this time?
Firstly, the Covid-19 recession was ultimately a real-economy problem, not a banking sector problem. As we have discussed previously, financial institutions have held up remarkably well during the COVID-19 crisis. Secondly, policymakers have employed a wider array of stimulatory responses; furlough, grants to businesses, bounce-back loans, stimulus cheques etcetera; fiscal policy has made a renaissance. Of course, when all you have is a hammer, everything looks like a nail, but with a broader range of alternative tools to hand, monetary policymakers will inevitably spend more time analysing QE's marginal benefits, and it won't necessarily represent the default option.
Whether the Bank of England halts all purchases in August or merely begins to slow the pace of purchasing later in Q4 this year, by 2022, less technical support will exist for gilts. Accordingly, some relative underperformance of gilts vis-a-vis global risk-free markets may arise.
Reducing technical supports clears the way for a policy rate hike next year from the current 0.1% rate. Looking at overnight index swap pricing to model the market's policy rate expectations, we can see expectations that this will have increased by 15 basis points by May 2022. However, that would still be a very accommodative rate in an environment where more permanence is attached to the current inflation rate. If the BoE is forced to curb inflation more aggressively, the policy rate has much further to rise, and we believe gilt yields will follow with associated negative returns.