After the UK markets suffered a flash crash in sterling last week and a really scary plunge in long dated gilts, sterling assets remain vulnerable to any monetary policy surprises or further fiscal shocks. The Bank of England is due to come up with a Goldilocks rate move at its next meeting on November 3rd and must neither over- nor under-hit.
The Federal Reserve is expected to hike its main borrowing costs by 75 basis points the day before the BOE meeting, while a similar move is expected from the European Central Bank on October 27th. British policymakers should follow suit; Britain has had enough of standing out from the crowd this year.
Futures markets have calmed down significantly after the turmoil triggered by Chancellor Kwasi Kwarteng’s recent tax giveaway. While traders still expect the current official interest rate of 2.25% to rise a full percentage point by next month, that’s significantly lower than the peak reached during last week’s turmoil. UK rates contracts have consistently priced in more than the BOE has delivered this year. But with double-digit inflation likely to be fueled further by the government’s fiscal liberality, the central bank needs to do more than repeat the half-point hikes introduced in its previous two decisions.
The UK government’s growth spurt, coupled with an open-ended plan to contain energy prices, may not erase recession risks but should support the economy. However, it is also likely to raise inflation expectations, requiring what BOE Chief Economist Huw Pill has twice called a “significant and necessary response”.
There is a case for a 100 basis point hike to really get a grip on consumer prices. Catherine Mann, one of three policymakers who voted for a bigger hike last month, has repeatedly said more action may be needed. Their main concern is that sterling will continue to weaken as US policy tightening continues and accelerates, and that inflation expectations are easing.
These are credible arguments and the BOE could easily justify an overreaction to the prevailing situation. But Britons are still facing a cost of living crisis; and sharply higher mortgage rates and rising bond market yields have already significantly tightened financing conditions.
Sterling has recovered about 10% against the dollar from its September 26th low of 103.50 but remains weak against the greenback; against the euro, the pound is roughly at its average value over the last five years. Pill said at a Sept. 27 event the BOE is not in a “race” to tighten policy, stressing that the MPC is not indifferent to market prices. But as long as markets remain calm, there is no particular need to defend sterling.
Next month’s meeting will include a quarterly review of the BOE’s economic forecasts. The MPC is likely to revise its GDP expectations upwards and possibly return to its May estimates of negative overall growth but no technical recession. Most important will be the forecast for future inflation, which at the August review called for a return to its 2% target in two years and a decline to 0.8% in 2025. Deviation in containing annual consumer price inflation, which hit 9.9% in August, would suggest that monetary policy is being tightened more quickly.
The BOE’s recent intervention to calm the gilt market has been a master class in managing a sudden liquidity crunch. By offering to intervene on a large scale, with an initial allocation of £65bn ($73bn), it has only had to buy £4bn of long-dated gilts so far. 30-year yields have fallen to around 4% from a peak of 5%.
Unfortunately, the reputational and economic cost to the UK of the recent market turmoil is likely to remain high as investors scrutinize the government’s fiscal policies more closely than ever. But at least the UK’s monetary institutions are working, as the Treasury’s Debt Management Office seamlessly ran four gilt auctions during the turmoil, one lasting 39 years. The sense of quiet professionalism exuding from the BOE has been the UK’s salvation of late. Long may it go on like this.
More from the Bloomberg Opinion:
• Gilt market problems are not unique to the UK: Richard Cookson
• The Bank of England should make its own U-turn on gilt selling: Marcus Ashworth
• Fixed income markets near a painful turning point: Mark Gilbert
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was Chief Markets Strategist at Haitong Securities in London.
For more stories like this, visit bloomberg.com/opinion
Comments are closed.