Bank of England set to hike rates to highest since 2009

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31 July 2018


Policymakers at the Bank of England will be meeting in Threadneedle Street this Thursday, with much of the market anticipating the bank’s first interest rate hike in the UK so far this year.

ollowing the BoE’s dovish message at its May meeting, policymakers reignited hopes that the bank could raise interest rates again this year during its June MPC meeting. At the June meeting, Chief Economist, Andy Haldane, surprised the market by unexpectedly becoming the third member of the rate-setting committee to vote for an immediate rate increase. Policymakers were split 6-3 in favour of keeping rates unchanged at 0.5%, following two straight meetings where hawks Ian McCafferty and Michael Saunders were the lone dissenters.

Rhetoric out of the central bank was also fairly hawkish, preparing the market for the prospect that other committee members could follow suit with Haldane at the upcoming meeting. The minutes claimed that ‘a number of indicators of household spending and sentiment bounced back strongly from what appeared to be erratic weakness’. Governor of the Bank of England Mark Carney further set the stage for an August interest rate hike during a speech at an event in Newcastle at the beginning of July. Carney again argued that the growth slump in the first quarter of the year was caused primarily by the adverse weather in the form of the ‘Beast from the East’, and should prove temporary.

Market pricing for an interest rate increase this week rose sharply back above 50% following the last MPC meeting, with the swap market now placing around a near certain 90% implied probability of a hike. It goes without saying that no hike from the Bank of England this week would therefore be seen as a major disappointment to the market, and would lead to a fairly sharp sell-off in the Pound. Sterling traders will, as always, be paying close attention to the vote on rates. At present, only Sir Jon Cunliffe appears opposed to the prospect of higher rates, with members Vlieghe and Tenreyro both suggesting that they could be ready to vote for a hike during respective speeches in recent weeks.

The market mostly overlooked the disappointing inflation data out in the third week of July, which economists deemed unlikely to derail a hike this week. Headline inflation remained stuck at 2.4% after investors eyed an increase to 2.6%, while the core measure, which strips out volatile energy and food components, declined to a more than one year low 1.9%. The still lofty level of headline inflation, which remains above the bank’s 2% target level, is undoubtedly one of the main reasons behind the need for higher interest rates in the UK.

Despite the latest inflation miss and the ongoing uncertainty over the Brexit negotiations, we think that the Bank of England will raise rates by another 25 basis points on Thursday, albeit the vote on rates is unlikely to be unanimous and could turn out to be rather close. We expect a hike to be accompanied by a reiteration that an ‘ongoing tightening of monetary policy over the forecast period would be appropriate’, although at a gradual pace. It is worth noting that Britain is the slowest growing economy in the G7, and thus the BoE will likely need to wait for a pick-up in economic activity before it is ready to even signal a faster pace of rate hikes. The bank will continue to highlight the major risks posed by Brexit, and Governor Carney will probably reiterate that the Brexit negotiations will be the biggest driver of interest rates in the UK.

We think that Sterling should receive some support from Bank of England policy this year, and believe that gains are on the cards for the still undervalued Pound against most major currencies during the remainder of the year.