he UK – BoE Makes 50bps Hike as Expected

The decision by the Bank of England (BoE) to step up its tightening cycle with its first 50 basis point (bps) rate hike fell within expectations and showed its willingness to act aggressively to tame inflation fuelled by worker shortages and supply issues. It took place at a time when the economy is leaning towards recession that could last over 4 quarters beginning from 4Q22.

Revising its projections, the Bank now foresee the local GDP to grow by 3.5% y/y in 2022 (below 3.75% in previous projection), and contract by 1.50% in 2023 (worse than 1.25% contraction in previous projection) while the CPI growth rate to reach 13% this year. Looking forward, with the BoE’s tone and willingness to act “forcefully” to curb inflation, there is a strong possibility of another 50bps hike in September. This can happen if both the Fed and ECB also raise rates by 50bps.

Window for Further Rate Hikes Closing

But the upside to the tightening cycle could come to a pause. The bank rate is reaching close to its peak rate which we expect to be at 3.00%. The window for further hikes appears to be closing as other key inflation drivers may start to ease though labour shortages will still be lingering.

Benign View of Gilt Needs to be Revisited

The BoE plans to sell £10bil of gilts from its QE portfolio every quarter for the next 12 months. This will start from September 2022. The focus will be on the private market’s ability to absorb more sovereign debt. The private market will have to increase their exposure to gilts by the same amount besides the usual deficit-financing.

This can raise the risk bar of a benign gilt yields view. And with our view that the QT target is £80bil per year while its passive reduction is only £36bil, this could mean the balance to be achieved via £44bil will be gilt sales. And our benign view of gilt risk needs to be revisited.

GBP/USD Remains Vulnerable in Near Term

We observed about a 0.5% drop in the sterling following the rate announcement and this was not a surprise. But the BoE’s narrative to remain aggressive despite the economy leaning towards recession is challenging. And we have the inversion of the UK gilt curve and a policy rate over 2% in September.

The GBP/USD remains vulnerable to the strong dollar amidst a difficult risk environment. The aggressive BoE tightening and an equally dim view for European growth prospects suggest that the EUR/GBP may continue to trade in the 0.83–0.84 range over the coming weeks.

Source: AmInvest Research - 5 Aug 2022