Can we breathe a sigh of relief?

June’s CPI print provides welcome relief to the MPC

As 2023 progressed, a certain level of doom-loop psychology had begun to take hold in the minds of many market participants when it came to judging the UK economy. The UK’s y-o-y CPI inflation rate overshot market expectations in every month from February to May, leading to interest rate expectations creeping up and up: on 1 March, expectations were for rates to peak at 4.75% but four months later this had jumped to well over 6% as concerns grew over inflationary pressures. The MPC was sufficiently concerned about UK CPI and other data that it unexpectedly increased rates by 50bp up to 5% at its June meeting. 

July needed to bring some good economic data for the Bank of England (BoE) to ease its interest rate hiking cycle. Labour market figures published on 11 July brought mixed news for the MPC. Annualised figures for nominal wage growth showed earnings of nearly 7%, both above expectations and at levels not compatible with a 2% inflation target, but the release did bring some encouraging signs of the labour market loosening. For example, both vacancies and inactivity levels saw a drop and the unemployment rate ticked up to 4%, which indicated that domestically-generated inflation from wage growth could begin to ease in the coming months. 

However, June’s CPI print, published on 19 July, was unequivocally good news for rate setters. June's y-o-y CPI reading registered at 7.9%, a marked drop from May's equivalent reading of 8.7% and significantly below market expectations of 8.2%. Granted, a fall in motor fuel prices led to the largest downward contribution to the drop in CPI but it is particularly encouraging that core CPI is showing signs of easing, too. Core CPI rose by 6.9% in the 12 months to June, down from 7.1% in May. The annual rates of both goods and services slowed. 

What’s more is that UK inflation will see another significant drop in July as the 17% fall in household unit energy prices shows up in the figures, which will leave y-o-y CPI inflation sub-7%. Other factors such as the fall in shipping costs and supply chain disruption should naturally help push headline rate to between 4 and 5% by year end although prices in the services sector, which are highly influenced by wage costs, could make returning to the 2% inflation target in the medium term challenging. 

The big controversy, of course, is all of the questions around the speed at which monetary policy is transmitting into the economy, and how this should affect interest rate decisions for the remainder of 2023. We are often reminded that monetary policy works with “long and variable lags” and those lags are likely to be both longer and, potentially, more variable than in the past given the growth of fixed-rate mortgages over the previous decade. The BoE will be publishing work on monetary policy transmission in due course. 

For now, it is clear that June’s inflation print gives the MPC a clear green light to slow its hiking cycle. A 25bp hike at the August meeting is now likely, followed by a further 25bp at the September meeting. We think the BoE will cease its hiking cycle at that point while markets continue to price in one further increase up to 5.75%.

Source: Macrobond

Note: Data comes from Pantheon and the Bank of England

Daniel Mahoney, UK Economist

Perhaps it was froth after all…

Finally, some good news on the inflation front and all looks very different from just a month ago. UK inflation for June fell more than expected, and fell on a broad scale too. Notably falls in annual core inflation to 6.9%, as well as a fall in services inflation from 7.4% to 7.2%, matter more to the Bank of England and subsequently market expectations.

In last month’s wrap it was noted that market expectations of a peak at 6.5% was indeed lofty, but was hard to say whether it was “frothy”. What made this more difficult was the deliberate ambiguity in the Bank of England’s statement at the June meeting about where rates could go, whereas previously there were hints that it thought market expectations had gone too far. But, data matters, even if its historical. Central banks are having to be more reactive to data as there are too many variables and unknowns in this inflationary cycle, and the latest numbers will likely provide a big sigh of relief in Threadneedle Street. Whilst the MPC will avoid complacency, the numbers should give it more confidence that an end to the hiking cycle is now in sight. Perhaps then we can say that it was indeed “froth”.

That is the view markets are now taking too, looking at the short-term, in July markets have priced out roughly 75bps worth of hikes in the next 9 months, with the peak dropping from 6.5% to between 5.75% and 6%. Markets are also pricing in a small chance of interest rate cuts starting in the summer of 2024. Worth noting that the majority of this reversal happened before the June inflation release, with global rates cooling after the last US inflation numbers which also slowed more than expected.

The surprise inflation numbers also ignited a readjustment lower in long-term rates, highlighted by a 20-30bp drop across the UK swap curve. The peak to trough fall in July is even more impressive, take the 5-year segment for example, with the swap rate falling from close to 5.5% to 4.7% now. We saw similar moves post the inflation release in the gilt curve too.

As for the early August Bank of England meeting, a 25bp hike to 5.25% now seems the most likely outcome, as markets have now more or less priced out the chances of a larger 50bp move. Therefore the potential for volatility on the day may have diminished all else being equal, however we will wait to see the vote split and supporting commentary to see if it provides any hints on what may be to come. Although, like most central banks, it is likely the BOE will refer to the idea of being data dependant.

Despite the Fed and ECB meeting in July, we will save any detailed analysis on those decisions for the August wrap where we have the outcome of the early August Bank of England meeting. Us, and markets, were not expecting any fireworks from the Fed or ECB anyway. The former, as expected, raised rates by 0.25% taking the Fed Funds band to 5.25%-5.50%.  As per its June forecasts, one more hike is expected this year, but markets are not convinced by that yet. This side of the Atlantic the ECB meeting was also uneventful, as a hike of 0.25% was effectively pre-announced by Christine Lagarde last month. What was more interesting to markets was whether there would be any more commentary around a further hike in the deposit rate to 4%, which was pretty vague. In the build up to the decision it was interesting to hear some rather dovish remarks from even the most hawkish members of the council, who suggested that another hike in September is no longer a certainty. More excitement came over in Tokyo where the Bank of Japan, unexpectedly, tweaked its yield curve control policy by no longer setting 0.5% as a rigid upper band, but instead a reference point. This allows longer term rates to rise above 0.5%, but falls short of an effective rate hike as the BOJ did not announce a new upper limit.

To summarise, after some brief divergence last month, the readjustment in the UK curve has seemingly realigned itself with its peers. And unless we get further inflation surprises, the peak is now in sight for all three major economies according the markets.

Cameron Willard, Capital Markets

All data, unless otherwise stated, is sourced from Bloomberg