The Bank of England wraps up its meeting with a decision Thursday. It is widely expected to remain on hold whilst acknowledging an improved economic outlook. Recent comments suggest little official concern yet about rising yields and so we believe gilt yields are likely to continue rising, lending sterling some support.
As we noted in our recent FOMC preview, curve steepening is a global phenomenon. The US and Australia are leading the pack due to their relatively strong economic performances. However, several major economies are not seeing the same degree of steepening such as Germany and Japan, as their economies have underperformed on a relative basis. Therefore, they may also be the most vulnerable to tightening financial conditions if curves continue to steepen worldwide. The UK is somewhere in between these two groups, with the successful vaccine rollout helping to offset some negative sentiment of the still murky post-Brexit landscape
POSSIBLE NEXT STEPS
After QE was expanded in November, the December meeting held no surprises. However, the last decision February 4 saw a less dovish than expected hold as the BOE presented a fairly upbeat outlook. While no action is expected this week, we outline some possibilities.
1. Jawbone yields lower – POSSIBLE NOW, LIKELY LATER IN 2021. Bank of England Governor Bailey just said this week that rising UK interest rates reflects optimism in the economy. This is the same tack that Fed Chair Powell has taken, and markets are growing increasingly jittery. Since the February meeting, the UK curve has steepened by 40 bp at the long end and 50-55 bp in the intermediate range. A much larger move than seen in Germany or Japan, but nowhere near the steepening of the Australian or US Treasury curves. During that time, sterling has gained 2% vs. the dollar, 3% vs. the euro, and 5% vs. the yen. While Bailey’s comments suggest little concern, we believe the BOE will eventually have to push back against the rise in UK yields. Next decision after this is due May 6.
2. Tweak its macro forecasts – VERY UNLIKELY NOW, LIKELY LATER IN 2021. The BOE updated its macro forecast at the February 4 meeting and won’t update them again until May. In light of the accelerated vaccine rollout and aggressive fiscal stimulus, the nearby macro forecasts should be upgraded significantly at the May 6 decision after modest changes were made in February. The GDP forecasts from February (November) were 5.0% (7.25%) in 2021, 7.25% (6.25%) in 2022, and 1.25% (1.75%) in 2023 while the CPI inflation forecasts were 2.0% (2.0%) in 2021, 2.25% (2.0%) in 2022, and 2.0% (2.0%) in 2023. Note Bloomberg consensus sees GDP growth of 4.7% in 2021, 5.7% in 2022, and 2.2% in 2023.
3. Tweak its forward guidance – VERY UNLIKELY NOW, LIKELY LATER IN 2021. At its most recent meeting February 4, the BOE left policy unchanged whilst saying “The MPC will continue to monitor the situation closely. If the outlook for inflation weakens, the Committee stands ready to take whatever additional action is necessary to achieve its remit. The Committee does not intend to tighten monetary policy at least until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably.” This forward guidance was identical to what was issued at the December 17 decision. It’s possible that the bank tweaks its statement tomorrow to acknowledge the improved outlook but we think it’s still too early to make any significant changes. Deputy Governor Ramsden talked about slowing the pace of QE in 2021 after the last meeting but we think he is an outlier.
4. Increase existing asset purchase programs – VERY UNLIKELY NOW, POSSIBLE LATER IN 2021. In November, the bank increased its asset purchases by GBP150 bln vs. GBP100 bln expected. Governor Bailey made a point of saying then that the increase in QE is not related to the government funding needs. However, given Chancellor Sunak’s aggressive budget, there will be increased gilt issuance ahead and the BOE may have to expand QE again this year if yields start to rise too much.
5. Tweak its lending programs – VERY UNLIKELY NOW, POSSIBLE LATER IN 2021. The BOE introduced a new Term Funding Scheme with additional incentives for small- and medium-sized enterprise (TFSME) last March, when it also cut the bank rate 50 bp to 0.25%. The scheme provides 4-year funding at a rate close to the newly lowered bank rate. The amounts were limited to 5% of total lending, but additional funding is available to banks that boost loans to small- and medium-sized enterprises. Later that month, TFSME was enlarged when the BOE last cut the bank rate 15 bp to the current 0.10%. Both the rates and the limits could be adjusted to provide more lending.
6. Introduce Yield Curve Control – VERY UNLIKELY AT ANY TIME. Like the Fed, we do not think the BOE is willing to embrace the open-ended QE that YCC requires. This is especially so given the expected recovery ahead due to the relatively fast vaccine roll out. But even before the recovery, BOE officials really never embraced the concept of YCC as much as they did, say, negative rates.
7. Negative interest rates – VERY UNLIKELY AT ANY TIME. Some BOE officials were regularly touting negative rates this past year. Indeed, prior to the February 4 decision, short sterling contracts were pricing in odds of negative rates by end-2021. However, at the February meeting, the bank said it was appropriate to prepare for negative rates but stressed it did not intend to signal that negative rates are coming. Since then, there has been little talk of negative rates and short sterling contracts have priced out negative rates and also moved forward the first likely hike to H1 2022 from H2 2023 previously. The threat of negative rates had helped keep the UK curve flat and the market now perceives that as being off the table. Instead, the BOE is stuck with a steeper yield curve and firmer sterling and that's going to be a headwind for the economy.
At the margin, rising UK yields and enhanced BOE tightening expectations should help boost sterling. The ECB and other major central banks are likely to follow the BOE (and the Fed) in removing stimulus much, much later.
Sterling tends to strengthen on BOE decision days. Of the ten last year, cable gained on seven of them. However, this record improved over the course of 2020 and into 2021,with cable rising the last five straight and seven of the past eight.