The calm before an autumn storm?

The heady days of summer

The UK economy continues its healthy expansion, driven by a consumer recovery in retail, as well as social spending. Accommodation and food service activities increased by 87.8% in Q2, (recent figures are being measured against the depths of last year’s downturn) while wholesale and retail trade increased by 12.8%, in response to the re-opening of indoor hospitality, Euro 2020 and the reopening of non-essential retail. Accommodation will receive a further boost in the months to come as international travel remains more difficult than it was pre-pandemic and many people are "staycationing" in the UK this summer; although, staff shortages may become problematic as the summer progresses. This driving force of consumer spending will naturally fade over the coming year as income that had been saved is fully reallocated back to pre-virus norms. But business investment will take its place as the dynamo in the economy and we expect this to expand by over of 12% in the next two years, driven by: the investment of as much as £120 billion in accumulated savings; the Budget generously having raised tax allowances for investment against corporation tax to 130%; and it is becoming is ever clearer where productive investments might be made. Taken together these factors result in our forecast for UK GDP expanding by 7.2% in 2021 and 5.6% in 2022, before tax rises needed to consolidate public finances begin to take GDP growth below trend to 1.3% in 2023. 

Finally some guidance on the way forward

The Bank of England Monetary Policy Committee (MPC) has given some clarity on their thinking about when monetary policy might be tightened, indicating they intend to maintain record low interest rates until the economy has recovered and average inflation is sustainably above its 2% target rate. As to the £895 in Quantitative Easing (QE), the Bank of England (BOE) will start to wind this down when interest rates reach 0.5%, which they suggested is likely to happen over the coming three years. We are forecasting interest rates to remain at 0.1% through 2021, before rising to 0.25% in the second half of 2022 and rising again to 0.5% in the second half of 2023. Inflation remains the danger. The Bank of England forecast in Feb 2021 that inflation would meet its 2% target by the year end, and in fact that level was reached by midyear. However, the Bank continues to believe, and we concur, that much of the inflationary pressure is transitory and inflation will fall back to its target level over the course of 2022, although not before it touches 4% by year end of 2021. Despite this and the unease the House of Lords Economic Affairs Committee has expressed about the Bank aiding monetary financing , investors remain relatively relaxed about the UK government’s overall financial position. 

As we hit peak summer trading conditions, rates have treaded in calm waters over the past month, as most traders and players tread actual water on their holidays. Whilst the narrative has not necessarily changed, the tone is still shifting in favour of higher rates – you only have to look at the latest BoE meeting and recent comments from officials at the Federal Reserve. This, as I have reiterated before, makes for an interesting autumn ahead driven by the actions of the central bankers across the pond, setting the direction for the rest of the rates market.

It’s all talk at the moment

There is always a lot of noise coming from members of the Fed, and we have to remember that of course some voices matter more than others, notwithstanding the fact they vote in cycles. Like with any rate- setting committee, you have the outliers who express more extreme views on either end of the spectrum. For example, in recent weeks we have heard from Fed members Raphael Bostic and Robert Kaplan who both sit at the hawkish end of the spectrum (albeit Kaplan has sounded less hawkish in recent comments). Atlanta Fed President Bostic called for a quicker tapering programme than in previous episodes whilst also looking for a rate hike “very late” in 2022. Whilst on the other end of the spectrum we have Neel Kashkari who has a concern that the delta variant could throw a “wrinkle” into the labour market recovery.

Markets have however barely battered an eyelid at these comments, so who will they listen to? Some put more focus on the Board of Governors, and narrowing the scope even more, comments from Chairman Jerome Powell (obviously), Vice Chair Richard Clarida and Governor Lael Brainard (who is favourite to succeed Powell if he is not give a second term) tend to have the market listening. These three have held more neutral stances, a balance between the two extremes, and therefore when the views of one or more start to shift it carries more weight. Powell has purposely kept his cards close to his chest, kicking the can down the road to future meetings and trying his very hardest to avoid a communication mishap. Vice Chair Clarida’s comments though have been a bit more fruitful, whilst not deviating from forecasts, he sees conditions for policy tightening being met at the “end of next year” and confirmed that an announcement on tapering plans will come before year end.

So as far as interest rate hikes are concerned, the Fed are leading the market to a 2023 move, but the market is not completely buying it at the moment. Eurodollar futures, a proxy for where the benchmark Federal Funds rate is expected to be in the future, still price in a first hike in late 2022 as shown below.

As most things do it will all boil down to data, and more importantly, jobs data. Employment numbers in the next month or two will be key in deciding the taper plan. The strong numbers for July (943,000 jobs added) on top of June’s numbers have already convinced some that a hint on taper plans could come later this month at the annual event held at Jackson Hole. I imagine we at least need employment figures for August before a decision is to be made – my view is a taper announcement in September, and taper commencement in December, although a November taper is just as likely. 

Longer- term rates will rise and the curve will steepen on signals the Fed provides rather than when tapering actually begins. Even if Jackson Hole is not the time and place for an official announcement, any hints of that getting closer should spark the market into action. Famous last words of course…

BOE certainly not on summer break

The Bank of England was not messing around in its August meeting, altering the path for future policy tightening and turning abruptly more hawkish. You only have to look at the statement which highlighted that members agreed that “some modest tightening of monetary policy over the forecast period was likely to be necessary to be consistent with meeting the inflation target sustainably in the medium term”. Although the timings of such tightening remained vague.

MPC member Michael Saunders, as expected, dissented, voting in favour of ending the quantitative easing programme early by reducing the size of the envelope. But the most important takeaway was the conclusion on the review into the thresholds required to start reducing the size of the bank’s balance sheet. Previously, policy stated that the Bank Rate had to reach 1.5% before any such reduction could occur, this threshold has been lowered to 0.5%. It is expected once Bank Rate reaches 0.5% the BoE will not sell bonds outright, but rather let them mature and not re-invest the proceeds. Outright sales would be considered if Bank Rate reaches 1%.

Based on market pricing which sees Bank Rate at 0.5% by the end of 2023, this suggests that balance sheet reduction is a few years away. But at the current pace of purchases the BoE will complete its QE programme at the end of the year, whereas the Fed’s balance sheet will continue expanding (just at a slower pace). I still believe the BoE will align itself to the Fed given the similar trajectories of the respective economic recoveries, and if the Fed’s timescale from ‘tapering’ to ‘quantitative tightening’ quickens to within the next two to three years, I would not be surprised to see the BoE move the goalposts and adjust accordingly.

The fact that medium term inflation according to the forecasts remains anchored around the 2% target or even lower, does suggest that the Bank of England seems comfortable with the current pricing of two rate hikes in that period – and fits in with “modest” tightening. So the direction for rates does seem higher, but at this stage a series of rapid rate hikes is not in the pipeline.

However as mentioned above, the impending ending of the BoE’s QE programme coupled with reduced purchases from the Fed will pressure longer term rates disproportionately higher, given that bond purchases are typically in longer- dated assets (3-10 years). This in turn will pressure swap rates higher. 5 and 10 year Base Rate swaps are back trading at 0.50% and 0.60% respectively, nothing dramatic, but a considerable break of these levels is a possibility based on levels seen only back in May/June – something to think about for those who are contemplating hedging. This does not mean rates will go ramping higher though, for context, Capital Economics see the 10 year Gilt yield at just 1.25% at the end of 2023.

All data points, unless otherwise stated, have been obtained from Bloomberg.

Cameron Willard, Capital Markets