AJ Bell press comment – 22 September 2022
- 18% chance of a half-percentage-point increase to 2.25% and an 82% chance of a three-quarter-point increase to 2.50%
- Two-year Gilt yield stands at 3.38% against the 1.75% headline base rate, with the ten-year Gilt yield at 3.30%
- Unlike the Fed with its dual mandate to manage inflation and employment, the BoE will likely only look to stem inflation
“According to Refinitiv, the markets are putting an 18% chance on a half-percentage-point increase to 2.25% and an 82% chance on a three-quarter-point hike to 2.50% from the Bank of England at Thursday’s meeting, but financial markets are wondering just how far the Monetary Policy Committee is prepared to go,” says AJ Bell investment director, Russ Mould. “Governor Andrew Bailey and his colleagues made a total mess of it by arguing inflation would prove transitory and insisting policy was ‘data dependent’. That leaves them catching up and investors in shares and bonds and traders in currencies could be forgiven for thinking that the Old Lady of Threadneedle Street may now overcompensate and tighten policy too much at a time when the economic outlook is already fragile.
“The 10-year bond, or Gilt, is usually seen the benchmark for UK Government debt and the ‘risk-free rate’ by which the relative attractiveness, or otherwise, of all other investment options and asset classes are judged. The 10-year yield looks to offer some guide as to the direction and possible limit of UK interest rates, if history is any guide, and going into Thursday’s MPC meeting it stands at 3.30%, whereas the base rate is 1.75%. A half-point or three-quarter-point hike would go some way to closing the gap.
Source: Refinitiv data
“But when it comes to where the Bank of England is prepared to take interest rates, the two-year Gilt seems to be an even better indicator, just as the two-year Treasury seems to be a more accurate guide than the ten-year in the USA.
“Although investors must accept that the past is absolutely no guarantee for the future, the UK bond market seems pretty good at working how far the Bank of England can push headline interest rates before something breaks – either the stock market, the economy or both – and it has to pause, pivot and start cutting again.
Source: Refinitiv data
“Going into Thursday’s MPC pow-wow, the two-year Gilt yield stands at 3.38% against the 1.75% headline base rate. That would suggest there are further hikes to come, with a rapid move toward and then above 3.00% on the cards.
“The Bank of England Base Rate last stood above 3.00% in late 2008, when then Governor Mervyn King was slashing interest rates to try and support the economy in the face of the Great Financial Crisis, so a rapid move there will be a new and potentially unpleasant experience for many borrowers.
“Markets are pricing in a peak of around 4.75% in the base rate by the time of the MPC meeting of May 2023, before the first cuts come in the second half of next year, so the two-year Gilt may have some catching up to do as well.
Source: Refinitiv data
“Bond vigilantes clearly believe the Bank of England has more work to do, with both interest rate increases and reducing the £863 billion of Quantitative Easing assets still on its balance sheet, if it is to rein in inflation and the economic damage that it can do.
“But Governor Bailey and the MPC have a difficult balancing act to manage. They are wary of inflation on one hand and the threat of a recession on the other, and the UK Government bond market is close to calling a downturn – at least if the yield curve is any guide.
“Usually, the further away the maturity (of lifespan) of the bond, the higher the yield it must offer to compensate holders for the greater risks involved – the longer the life of the bond, the more scope there is for something to go wrong in the form of inflation, higher interest rates or even default.
“Right now, the yield on Gilts across a range of maturities from two to fifty years is broadly similar, leaving the yield curve looking pretty flat.
“At least it is not inverted, as it is in the USA where the yields on longer-dated instruments are below that on offer from the US one-year Treasury bill. Such an inverted yield curve is often seen as a sign that recession is coming, because it implies the Fed will start to cut rates at some stage in the future to try and stimulate growth.
Source: Refinitiv data
“Even so, the UK is teetering on the economic precipice if a shorthand summary of the yield curve is to be believed.
“This quick guide can be followed by tracking the yield differential between the two-year and ten-year Treasury. This indicator does occasionally give false signals but 2s-10s inversions, whereby the ten-year yield is below that of the two-year instrument, forewarned of UK recessions or slowdowns in the early 1990s, the turn of the Millennium and also before the Great Financial Crisis swept around the world.
“The 2s-10s curve briefly inverted from mid-August to early September but it has since gone back to being flat, perhaps buoyed by the tax-cutting and deregulating tone of the new Truss-Kwarteng administration, as well as the offer of support with energy bills for households and businesses alike.
Source: Refinitiv data
“Unlike the Fed, which has a dual mandate to manage both inflation and employment, the Bank of England has but one mission, namely to keep inflation around the 2% level.
“As such, if push comes to shove, the MPC should be prepared to risk a recession to keep prices broadly stable, even if the new Government is unlikely to be too thrilled about the prospect of any economic downturn as it seeks to curry favour with the electorate ahead of the next General Election, which must take place by early 2025 at the latest.
“When the 2s-10s curve inverts, the Bank of England usually sense trouble and starts to cut interest rates and ease monetary policy. This is what happened in the early 1990s, late 1990s, early 2000s and 2007-2009 (as well as 2020 when COVID broke out and the curve flattened but did not quite invert).
Source: Refinitiv data
“This time the Bank of England is not loosening policy as the Gilt market fears a recession but tightening it with rate increases and Quantitative Tightening. Perhaps the mini-Budget to be launched by the new Prime Minister and new Chancellor will offer sufficient fiscal stimulus to compensate for tighter monetary policy, but if that tax-cutting boost stokes demand and further feeds inflation then the Bank of England will be faced with yet another quandary.”
