Sterling forecasts vary as markets call for a 75 basis point rate hike

The Bank of England’s (BoE) Monetary Policy Committee (MPC) is due to announce its latest monetary policy decision on Thursday. The meeting was scheduled for September 15 but was postponed a week due to the Queen’s funeral.

There is no doubt that the MPC will hike rates again, but given the conflicting domestic pressures and the global rush to raise rates, there is a lot of uncertainty surrounding the policy decision.

Ahead of the decision, the bank knows there will be a cap on retail and corporate energy prices, but official estimates of the costs have not yet been released and there is a wide range of estimates given the scope for large fluctuations in gas prices.

The government is also set to announce a fiscal event on Friday with expectations of significant tax cuts.

According to ING; “[This week’s] The Bank of England meeting is crucial. It will show us not only how concerned policymakers are about the fall in sterling and other UK markets, but also how the government’s decision to cap energy prices for households and businesses will affect monetary policy.”

A slim majority of economists polled by Bloomberg expect the BOE to hike interest rates by half a percentage point to 2.25%. However, markets are pricing in around a 70% chance of a 75 basis point hike, with some banks calling for an unprecedented 100 basis point hike.

Sterling will fall 50 basis points in an immediate reaction to a rate hike and with an initial bounce if there is a 75 basis point hike, but with high volatility and inevitable sharp moves.

Fears of recession still valid

The economy has shown very clear signs of slowing down with a particularly weak retail sales report for August. Rising energy and food prices will keep consumer spending under pressure.

bannerHowever, the government has already announced that retail energy prices will be capped for the next two years with a 6 month cap on business expenses.

The support measures will cushion the downturn. However, fears of recession will still lead to some calls for monetary policy restraint within the BoE.

According to Barclays; “The widening economic slowdown poses a growing challenge to any further tightening, we expect dissenting moderate voices to grow louder.”

Added Danske Bank; “We expect the Bank of England (BoE) to hike interest rates by another 50bps to 2.25% at its next meeting. We expect 50bps versus 75bps as we are more negative on the growth outlook. The BoE has also tended to surprise the dovish side at recent meetings.”

The bank also pointed to fears of growth; “The BoE became the first G10 central bank to forecast a recession by Q4 2022 at its last meeting, while using far more dovish market pricing as policy input than is currently the case. We see this as a contributing factor to our base case as the growth prospects look significantly worse now than they did then given current market prices.”

The BoE cannot ignore fiscal largesse

The move to cap prices will have a major impact by keeping the inflation rate relatively close to current levels, contrary to previous expectations of a further increase to at least 15%.

The package to cap energy prices will also have a major impact on aggregate demand and government debt.

ING pointed out that Chancellor Kwarteng will give a significant boost; “He has already positioned himself as pro-growth and the mini-budget should include details of the £100billion-plus energy support package plus a further £30billion-plus in tax cuts.”

Looser fiscal policy would tend to increase the pressure to tighten monetary policy, especially given the vulnerable sterling.

Ellie Henderson, economist at Investec, thinks it is unlikely that the BoE will criticize government policies, but there will inevitably be repercussions on its policy decisions.

She added; “They will cool the economy at a time when the government is trying to stimulate demand through fiscal policy. There are differences in the policy path, but at the end of the day the BoE is independent and its main objective is price stability.”

Howard Cunningham, Fixed Income Portfolio Manager at Newton Investment Management, commented: “While the energy price cap will result in headline inflation being significantly lower than previously forecast, other expected fiscal measures should be stimulative.”

Global dimension extremely important

The BoE will inevitably need to take international developments into account, particularly given the implications for sterling.

The ECB raised interest rates by 75 basis points at this month’s meeting and there are very strong expectations that the Federal Reserve will approve a rate hike of at least 75 basis points this week.

Sweden’s Riksbank also hiked rates by 100 basis points to 1.75% at its meeting this week.

Global tightening will increase pressure on the BoE to become more aggressive and a 50 basis point rate hike would be seen as unconvincing which would tend to hurt sterling as yield spreads against the British currency move.

According to Samuel Tombs, UK chief economist at Pantheon Macroeconomics; “The MPC is currently cornered and needs to raise interest rates quickly to prevent sterling from depreciating further and to send a signal to households that it is serious about fighting inflation.”

Sanjay Raja, senior economist at Deutsche Bank, commented; “A steeper move would stem the pound’s slide against the US dollar and offset inflationary pressures unleashed by the government’s cost-of-living support package and bolster the bank’s credibility in the fight against inflation.”

John Hardy, Head of FX Strategy at Saxo Bank added; “The Bank of England has to go 75, it has to match its global competitors here if we’ve seen cables [pound-dollar] Trading at the lowest level since 1985. It would be quite a dodgy performance by the Bank of England not to target 75 basis points at this week’s meeting.”

Paul Hollingsworth, chief economist for Europe at BNP Paribas added; “The case for a 75 basis point hike is more compelling than for a 50 basis point hike.”

JPMorgan sees case for more aggressive tightening; “Opinions are evenly divided, but we see clear reasons for a bigger step. It added; “A 50 basis point hike would amount to a cautious surprise, and that would be difficult to justify after a large, unfunded and ill-targeted fiscal easing that has been accompanied by falling confidence in the markets.”

Analysts at investment platform AJ Bell noted; “It remains to be seen whether the BoE will be able to support sterling with the help of a bold rate hike and hawkish comments.”

Sterling in trader’s crosshairs

Commerzbank expects that the key element is that real interest rates will remain well in negative territory; “With an inflation rate of 10%, it makes little difference whether the policy rate is 25 basis points higher or not. At 2.25% and 2.50%, respectively, they remain far too low to send a clear signal that real interest rates could at some point become anything but significantly negative again.

It added; “Not only would the BoE need to keep raising interest rates, it would also need to ease inflation. But that won’t happen any time soon.”

Hardy from Saxo Bank added; “If the Bank of England doesn’t manage to hike 75 basis points, we should keep our eyes on what’s going to happen here with the pound.”

According to Chris Weston, head of market research at Pepperstone, there is scope for short-covering; “Given the strong downtrend in GBP, it’s easy to assume that the speculative part of the market is already heavily short GBP. This should cushion the downside on a 50 basis point raise, but see a clear move higher if we see a 50 basis point raise See 75 basis points.”

Nordea chief analyst Jan von Gerich added; “The momentum is weak and the movements have been strong,” he said. “We should see stabilization at some point, but it’s hard to say when that will come.”

According to Credit Suisse; “If 50 basis points turn out, we suspect EUR/GBP 0.9000 (1.11 for GBP/EUR) and GBP/USD levels below 1.1000 could come quickly.”

It adds; “For GBP to recover, we would need to see the BoE use the excuse of the government’s massive fiscal easing to radically change its hitherto dovish stance and move to hikes in the range of 75-100 basis points, with a confirmation of the Market’s final pricing in his commentary. In this scenario, we envision that GBP/USD could attempt to retest the 1.1700 level and EUR/GBP could fall back to 0.8500.” (1.18 for GBP/EUR).

New member on committee, high risk of split decision

External MPC member Saunders left the bank after the August meeting and will be replaced by Swati Dhingra, whose views on interest rates are not well known.

According to ING; “We favor around 50 [basis points] Hike on Thursday, taking the benchmark rate to 2.25 percent despite 75 [basis points] is clearly on the table and we would expect at least a few policymakers to vote in favour.”

added ING; “It’s even possible we could get a rare three-way vote — the first since 2008 — if reticent committee member Silvana Tenreyro votes for a 25 basis-point hike, as she did in August.”

Given the high level of uncertainty, the Bank will be very reluctant to provide forward-looking guidance or clarity about future decisions and will need to keep options open.

Gilded sales could be delayed

The BoE plans quantitative tightening by selling bonds back to the market.

The bank expects the mix of active sales and maturing gilts to reduce its holdings by £80bn over the next 12 months, with direct sales of £10bn a quarter.

However, yields have risen sharply and the government’s fiscal stimulus will provide a strong boost to gilt issuance.

Investec economist Ellie Henderson noted; “Questions have been raised as to whether this is the right time to start selling gilts back in the market.”

The latest government bond data saw interest payments hit a record high, adding to concerns about the impact of gilt selling.

Newton’s Cunningham added; “They may choose to delay the start of active selling of Gilts as they recognize the additional supply of Gilts that is coming soon.”

There will tend to be more room for rate hikes where gilt selling is limited or delayed.

Leave a Comment