Bank of England Update: Mixed Growth Outlook, But Higher Inflation Expected to Materialise

7 November 2016

Rates & FX View

Bank of England Update: Mixed Growth Outlook, But Higher Inflation Expected to Materialise

Highlights

Highlights

¨                  The Bank of England’s Monetary Policy Committee (MPC) decided to maintain the status quo in its latest policy meeting (Bank Rate at 0.25%, total QE stock at GBP435bn), although the rhetoric appears to be more hawkish than expected.

¨                  Inflation is expected to surge beyond BoE’s tolerance; arguably shift towards a more neutral policy stance.

¨                  Another important Brexit development overnight concerns the High Court ruling, denying UK government the ability to trigger Article 50 without Parliament’s approval, complicating negotiation timelines.

¨                  We now expect BoE to hold its monetary policies over the foreseeable future, with the hurdle towards any shifts in policies likely to be high. Brexit developments and economic data trends remain key drivers in UK policy trajectory.

¨                  Our mildly bearish GBP stance remains appropriate; downgrade our Gilts view from mild overweight to neutral.

¨                  In view of our revised Gilts view, we decide to close off our 5/20y Gilt flattener as soon as possible when the opportunity arises.

MPC Update

The Bank of England’s Monetary Policy Committee (MPC) decided to maintain the status quo in its latest policy meeting (Bank Rate at 0.25%, total QE stock at GBP435bn), although the rhetoric appears to be more hawkish than expected. The decision is likely to be driven by a few factors: i) stronger growth trajectory; ii) higher inflation projections in light of the recent sharp GBP depreciations; iii) conserve policy space in the face of lingering uncertainties surrounding the exit process; and iv) pressure from pro-Brexit lawmakers calling for governor Carney’s resignation. While GBPUSD surged post-meeting (+1.28% overnight), movements in the rates market are more subdued, with the OIS SONIA curve little changed and the rise in 10y Gilt yields overnight (+3.1bps) are comparable with that of the 10y Bund yields (+2.8bps). We have previously noted that BoE’s assessment of the future is likely the more critical medium-term driver than the monetary decision itself.

BoE arguably shifted towards a more neutral policy stance, noting that UK monetary policies “can respond in either direction”, a marked shift from the September MPC statement. In view of the new information, we now expect BoE to hold its monetary policies over the foreseeable future, with the hurdle towards any shifts in policies likely to be high at the current juncture; Brexit developments and economic data trends, inflation in particular, remain key factors in future policy trajectory.

One key point of content is the extent of BoE’s tolerance towards inflation overshooting. The MPC statement highlighted that “there are limits to the extent to which above-target inflation can be tolerated”. Inflation projections for end-2017 and end-2018 were revised higher to 2.7% and 2.7% respectively (Aug: 2.0% and 2.4%), suggesting that the tolerance for overshooting may be somewhere in the 50bps range; BoE is likely to keep a keen eye on second-round effects (due to the weaker currency) and UK’s output gap. 2017 growth forecast was also revised higher to 1.4% (Aug: 0.8%) attributed to recent strength in UK economic data and consumer spending, although 2018 forecast was downgraded to 1.5% (Aug: 1.8%), citing the impact on investments due to the prolonged period of uncertainty.

The BoE remains cognisant towards persistent uncertainties plaguing the exit negotiation process, instead of a one-off spike ahead of the triggering of Article 50, and remain of the view that such fears may have negative impacts on confidence and investments. Given the likelihood that the exit process may be dragged on by exogenous factors and political considerations (both in the UK and EU), conditions are likely to remain volatile and fluid, with a degree of unpredictability.

Prior to the BoE policy decision, another important Brexit development concerns the High Court ruling, denying UK government the ability to trigger Article 50 without Parliament’s approval; GBPUSD climbed c.0.5% intraday on the news. It effectively gave MPs the opportunity to review the government’s negotiation plans, while pro-European MPs are likely to take the chance to “soften the Brexit”. The government will appeal to the Supreme Court, who may still overturn the decision. While the chance for a “softer Brexit” should be GBP-positive, political tension is likely to escalate amid Parliamentary debates, which could delay the triggering of Article 50 and introduce further uncertainties around the negotiation process.