The Bank of England will review policy and update its economic forecasts on Thursday, a day after the Fed, with the announcement due at 12:00 GMT. A rate hike is already baked in, but it’s unclear just how aggressively the central bank plans to act, as the toxic mix of spiraling inflation and slowing economic growth makes any decision in either direction risky.
BoE is the only player in town amid stagflation fears
British Prime Minister Boris Johnson, living on a tight household budget, has made it clear that government spending will not be enough to immediately offset the rising cost of living for all but the unfortunate families. In particular, he explained that increased financial support could fuel inflation at a time when consumers are already facing higher taxes and soaring energy bills. Therefore, in the short term, the central bank will likely be the only player in town aiming to cool inflation before the economy erodes it due to a slowdown, or in other words, before it slips into stagflation.
But the work will not be easy. Unlike the Fed, the BoE has taken a cautious approach in its era of tightening, notably voicing concerns about faster rate hikes, despite inflation hitting a fresh three-decade high of 7.0% y/y in March and later in the month Year could rise even higher according to the BoE’s earlier projections. A tightening of inflation expectations is probably the last thing policymakers want by cutting stimulus quickly as the string of higher highs in bond yields shows no sign of abating, with the 10-year yield recently hitting a seven-year high reached just over 2.0%. The higher yields rise, the higher the cost of borrowing for companies and the greater the risk of an economic slowdown. Note that the inversion of the negative yield curve is relatively steeper in the UK than in the US, while that for the eurozone is interestingly flat – a yield curve inversion is a signal that investors fear the economy is going down, when it is not the case should be taken for granted.
Avoid sharp rate hikes
Of course, the war in Ukraine and pandemic-related supply disruptions in China, which are the main drivers of global inflation, are beyond the central bank’s control, although it would be imprudent for policymakers to abandon their tightening plans entirely, as inflation risks look more real than current growth risks .
As such, the board is likely to approve another rate hike this month, taking the benchmark interest rate to its highest level since 2009, but it may forgo bigger hikes and instead deliver a normal 25 basis point rate hike, as investors widely expect. Such a rate hike could even be seen as a moderate move compared to the 50 basis point rate hikes in Canada and New Zealand and could therefore still be in line with the BoE’s April guidance. However, it remains to be seen how divided the voting body will be. Currently, investors expect eight out of nine policymakers to support a 25 basis point rate hike. Also, with the savings rate disappearing and real income turning negative, the economy could be more vulnerable to sudden financial shocks. Keep in mind that retail sales fell to 0.9% yoy in March from 7.2% yoy. Policymakers could provide some direction on the economic outlook when they release their new GDP and CPI inflation forecasts this week.
sale of bonds
Another key question, and perhaps the most important, is how the central bank will manage its £875bn gilt portfolio. Policymakers had previously said they would consider selling government bonds once interest rates hit 1.0%, but given the current unfavorable economic environment and sanctioned Russian deals, the central bank could delay quantitative tightening measures. Perhaps by announcing a consultation period, there could be some time for reflection and data scrutiny before policymakers release specific details on when and how bond sales will be conducted.
GBP/USD
In terms of market reaction, futures markets are pricing in a 65% chance of a 25 basis point rate hike. Such a rate decision could be seen as conservative, especially if the central bank paints a gloomier picture for the UK economy and postpones all bond selling activity. Therefore, the pound/dollar pair could drop below the 1.2410 low and continue towards 1.2312 – this is the 61.8% Fibonacci retracement of the 2020 rally. Price could turn lower around the May 2020 low stabilize from 1.2074.
In the bullish scenario, where the BoE meets expectations of a normal 25 basis point rate hike but sets a timeline for when and how quantitative tightening might take place, or in the most hawkish case hike rates by 50 basis points, the pair could see its recovery from Extend out of 1.2410 and towards 1.2670 former support area. Furthermore, the next target will be the 20-day simple moving average (SMA) and the 1.2820 level.
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