Image © Pound Sterling Live, again courtesy of Bloomberg TV.
The pound came under noticeable pressure after the Bank of England raised interest rates but warned the economy was set to slow sharply in the coming months and inflation could even peak at 10% higher late in the year.
The Bank of England raised interest rates by 25 basis points to 1%, as expected.
The Bank’s Monetary Policy Committee (MPC) voted by a 6-3 majority to raise the bank rate, with the three dissenters seeking a more substantial 50 basis point hike.
MPC members Haskell, Saunders and Mann expressed their dissent according to minutes of the political meeting.
This vote share was therefore on the whole ‘hawkish’ and would have supported the pound if the rest of the policy update and associated economic forecasts in the Monetary Policy Report had turned out to be so ‘accommodative’.
The economic forecasts and assumptions presented by the Bank on Thursday offered a powerful mix of negativity regarding the UK’s economic outlook and investors sold off the pound sterling which fell sharply against all major currencies.
The exchange rate between the pound and the euro fell 1.00% to 1.1750, the exchange rate between the pound and the dollar fell 1.75% to trade at 1.2399. (Set your exchange rate alert here).
Above: GBP/EUR and GBP/USD at 5 minute intervals showing the impact of the Bank of England’s policy update.
The Bank has also been more cautious in engaging in quantitative tightening – the process by which it sells bonds purchased under quantitative easing back to the market – which it said it would begin once that the discount rate would reach 1.0%.
The Bank said it would only begin to consider quantitative tightening, which may have contributed to the market’s assessment that this was a “pacifist” political event for the pound.
“We continue to see more downside risk for the GBP due to an impending slowdown in growth, record real disposable income weighing on the UK consumer and heightened political uncertainty that has yet to be resolved. embedded in the currency, in our view,” says David S. Adams of Morgan Stanley.
The Bank’s revised inflation forecast shows that CPI inflation is expected to rise further over the rest of the year, reaching just over 9.0% in the second quarter of 2022 and a slightly higher average 10% at its peak in the fourth quarter of the year.
CPI inflation is expected to drop slightly above the 2% target in two years.
The Bank sees high inflation expectations taking root, saying companies now generally expect to raise their selling prices sharply in the short term, following their sharp rise in costs.
The cap on energy prices means that inflation will peak later in the UK (prices will rise again in October) and stay high for longer compared to other countries.
May Monetary Policy Report at the same time, a central projection of UK GDP growth is expected to slow sharply in the first half of the forecast horizon.
In fact, economic growth will contract in the last quarter of this year as the cost of living crisis intensifies and calendar year GDP growth is expected to be broadly flat in 2023.
Although the unemployment rate should continue to decline slightly in the short term, the Bank now expects it to rise to 5.5% in three years due to lower economic growth rates.
“Growth downgrades and prolonged high price pressures are not comfortable amid continued political uncertainty. short-term,” said Jeremy Stretch, strategist at CIBC Capital Markets.
The language of the report meanwhile suggests that further rate hikes are likely, with the Bank noting that “the Committee judges that some degree of additional monetary policy tightening may still be appropriate in the months ahead.”
The UK economic outlook is decidedly bleak, ensuring that the outlook for the Pound is tilted to the downside.
Above: BoE economic projections for May, compared to February forecasts (in parentheses).
The above economic forecasts are made based on the market assumption that Bank of England interest rates will rise to 2.5% in 2022, before falling back to 2.0% in 2025.
This is important as the Bank effectively communicates that, based on current rate hike assumptions, the UK economy will stagnate and risk falling into recession.
This will inevitably force markets to rethink which will likely lower expectations for the number of future rate hikes at the Bank.
It is this revision of expectations that weighs on the pound.
The market was expecting another 25 basis point hike for each rate meeting during the year.
But Commerzbank economists expect the Bank to start taking breaks between meetings, averting a series of back-to-back rate hikes.
“If this happens after today’s meeting, market expectations for rate hikes could be corrected slightly lower, putting pressure on the pound,” You-Na Park-Heger said. , FX strategist at Commerzbank.
“Most of the headlines have been the BoE’s growth forecasts,” said Robert Wood, UK economist at Bank of America.
The Bank cut its GDP growth forecast for 2023 by 150 basis points to -0.25%, if current market expectations of future interest rate hikes are met.
It should be noted that the Bank’s projections show a much more benign set of results if the bank rate were to remain at the current level of 1.0%. In this scenario, GDP would continue to grow in all quarters of the forecast period:
Above: GDP results if rate hike expectations follow market assumptions vs. if the bank rate were held at 1.0%
But, in a scenario where the Bank Rate remains at 1.0%, inflation projections are significantly higher than in the scenario where the Bank Rate follows the upward market path:
The Bank will therefore continue to raise rates, but at a much slower pace to ensure that it lands in an intermediate country where inflation is falling, but while minimizing the impact on growth.
Bank of America stands by its call for three more 25 basis point hikes on top of the May hike and a cut in 2023.
“We continue to expect the BoE to hike rates by 25 basis points in June, August and November, with risk shifting today in our view the BoE will only hike twice more,” said Wood.
The market will inevitably reduce the number of rate hikes it expects following May’s Bank of England event, dragging the pound lower.
But the Bank appears to be ahead of the curve here: the UK is no worse off than many other developed countries in terms of inflation and slowing growth prospects.
Therefore, it is highly likely that other major central banks will begin to communicate a similar message as the reality of the coming growth slowdown emerges. It would be at this point that the pound could begin to make a material recovery.
It is however in at least two months.
“Remember the BoE was among the first to rise…and is leading the G10 central bank tightening cycle. Today’s BoE narrative = tomorrow’s Fed narrative (and the ECB is well behind the curve). This could be a significant inflection point for emerging market bond markets,” says Viraj Patel, FX & Global Macro Strategist at Vanda Research.