BoE edges closer to first cut

June MPC minutes suggest August rate cut remains in play

By the time of the next rate wrap, we will know the result of the UK 2024 General Election. It is notable that there have been many occasions in the past when political risk in the UK has been a major influence on the economic and market outlook. For example, when the exit poll for the 2019 general election was published and showed a comfortable Conservative majority, this was followed by firm approval in financial markets. There was a sharp appreciation in UK stock markets and sterling saw a jump against the dollar (see Chart 1). However, no such movements in financial markets are expected on polling day at this election given political risk is perceived to be low.

Markets have fully priced in a Labour government and are very comfortable with a prospective Starmer-Reeves administration. In fact, the main political risk to financial markets currently lies across the Channel in France, following President Macron’s surprise calling of a parliamentary election. The prospect of gains by Marine Le Pen’s National Rally party has put significant pressure on spreads between French and German government bonds, which Cam addresses in further detail in this month’s view from the Dealing Desk.

Turning back to UK domestic matters, the Monetary Policy Committee (MPC) announced its latest interest rate decision on 20 June. This, of course, took place in the midst of a General Election campaign, leading to some speculation that rate setters would not cut rates due to fears about being seen to interfere in the electoral process. While the Bank of England (BoE) did, of course, end up holding rates at this meeting, I do not subscribe to the view that politics would have played a role in this decision under current circumstances, or for that matter any other circumstances. The MPC has been at pains to stress that this and other interest rate decisions will be “data dependent”. 

In advance of June’s MPC rate decision, CPI inflation hit the BoE’s 2% inflation target (see Chart 3) but this does not mean “job done”. Inflation will rise again by year end due to base effects in the energy component of CPI and various metrics being tracked by the MPC remain elevated. Both the MPC’s voting breakdown and overall positioning remained the same in June as they did in May: seven members voted to freeze rates; two voted for a 25bp cut; and the majority of MPC members will continue to monitor for signs of inflation persistence in wages, services inflation and labour market tightness.

For there to be a fall in base rate in August, three additional MPC rate setters will need to back a cut. Subject to inflation and labour market data not throwing up any surprises, those MPC members backing a rate freeze in June but subscribing to the “dovish” view on current high services inflation will very likely move their vote for a rate cut in August. So, while the MPC minutes do not give information about the number of MPC members who lie in this camp, they nonetheless give a good indication that a rate cut in August is very much in play. Our view remains that the first rate cut of this cycle will, indeed, be in August with markets (as of 24.06) predicting a 67% chance of this occurring.

Daniel Mahoney, UK Economist

Summer is here, and things are starting to heat up

June was tipped to be a big month for central banks earlier this year, and whilst events may have not materialised as expected, unsurprisingly it was still a busy month. As previously noted in the Rate Wrap we did see interest rate cuts in both Canada and the Eurozone, both cutting rates by 25 basis points to 4.75% and 3.75% respectively. Despite the symbolic moves, what matters more is whether we see a string of cuts following. This is unlikely, with both the Bank of Canada and the European Central Bank deliberately not committing to a future path, albeit domestic weakness in Canada means this remains a risk. In the case of the Eurozone this especially makes sense following the latest inflation print which came out higher than expected (annual core inflation at 2.9% vs 2.7% expected).

The above was overshadowed however by two other key events in June — one as usual being US data. The data for May provided some mixed messaging in the payroll data, where nonfarm payrolls increased by 272,000 and average weekly earnings increased by 0.4% month-on-month. The unemployment rate did tick up to 4% though — moving in line with signals provided by survey data and jobless claims that suggest the labour market is weakening.

The CPI inflation data was the main event, and provided positive signs for the Federal Reserve in its battle against inflation. Markets have focused on the monthly pace of core inflation, which has been running at an average pace of 0.3% in recent months, a pace that is not consistent with annual inflation converging towards the 2% target. However CPI for May printed at 0.2%, and if we take out the rounding it is even lower at 0.163%. Numbers like this are what the Fed wants to see, and going even further, the “supercore” number – ex housing — was actually negative on the month.

That same day we also had the June Fed meeting, which included an update to the interest rate forecasts via the ‘dot plot’. The adjustments to these forecasts, where the median expectation now only points to one interest rate cut this year (down from three, markets expected a drop to two cuts) was a more hawkish development, but these forecasts were finalised prior to the latest numbers – therefore markets placed more weight on the CPI data. Fed Chair Jay Powell in his press conference welcomed the latest data, although caveated that he did give his team the chance to update their forecast which led to nothing material.

As for markets, we have seen downward pressure on long-term yields in the US, helped by strong demand in new auctions across the curve too. The US 2- and 10-year yields now reside in the 4.65% and 4.2% areas respectively. On the latter, clearly 4% is the short-term target if markets build in further rate discounts over the summer, however any move below may prove tricky, especially if risk premium starts to build as focus turns towards US elections and the ever growing concern over the US fiscal deficit. For 2024, momentum is growing for a September cut in the US with 20bps of cuts priced-in, with a full cut priced-in by November and two by December. Similar odds for a September cut in the Eurozone are followed by a smaller risk of another cut thereafter...

Political Divergence

A key development in financial markets this month was French President Emmanuel Macron calling for a snap parliamentary election following the results of the EU elections in early June. Macron’s party suffered a heavy defeat in the EU elections, picking up only 15% of the vote, whereas Rassemblement National (RN), led by Marine Le Pen, were the clear winners. Despite EU election turnout being typically a lot lower than domestic elections, it looks likely that RN will do very well in the upcoming vote according to polls, whilst the newly formed left-leaning coalition – the New Popular Front (NPF) – is just trailing in the polls. Support for Macron’s bloc is expected to crumble.

Therefore markets are adjusting to a new government where Macron will likely be a lame duck President until 2027, whilst having to appoint a prime minister led by one of the other two blocs, depending on the outcome. This reality has spooked markets, as seen especially in the French bond market, illustrated below by the rise in the absolute yield of the 10-year OAT and its spread to the 10-year German Bund. 

Although not at the levels of the Eurozone debt crisis, the spread of the latter is back close to levels seen during 2016, post-Brexit and prior to the 2018 Presidential election where Le Pen went up against Macron, and markets were dealing with a prospect of “Frexit” should Le Pen get in. This time, markets are on high alert around the health of the French budget, after the European Commission placed France in an excessive deficit procedure after posting a deficit in 2023 of 5.5% of GDP. Concerns stem from pledges from the RN to lower VAT on the likes of energy and fuel, whilst the NFP plans involve significant spending (EUR 25bn spending plan for 2024, and another EUR 150bn by 2027). In reality these pledges will be watered down, especially if the market has a tantrum – sound familiar? (hint-hint, Sep 2022)

In May we spoke about central bank divergence, but this month we look at political divergence – from the chaos in Paris to the relative calm in London. Markets remain laissez-faire on the potential outcome of the UK election, even after we have seen the manifestos. Both Labour and the Conservatives have broadly pledged to keep the existing fiscal rules in place. The lack of headroom in public finances is a headwind to all parties, which has drummed up more extreme discussions such as whether bank reserves held at the BoE should be renumerated differently. It is not expected that we will see any change here, but highlights how politicians are increasingly thinking outside the box to generate fiscal headroom. Whoever is victorious can look to the 2022 mini-budget debacle and the current situation in France as evidence that markets are increasingly sensitive to the outlook for public finances, which will limit their room to enact significant stimulus measures.

BOE cut delayed by the Taylor Swift effect?

The Bank of England stood pat in June, voting 7-2 again in favour of hold with both Dave Ramsden and Swati Dhingra dissenting in favour of a cut. Not much has shifted from the May meeting to tilt the voting this time with the key criteria set by the BoE in May - namely services inflation and wage growth - remaining more or less unaltered. But as Dan mentioned above, the decision for some not to cut was “finely balanced”. 

Momentum post meeting towards an August cut grew, with markets now assigning a 60% chance to such a scenario. We have mentioned before the majority of MPC members are leaning towards a cut, but concerns over services inflation remain. September may be more palatable, and markets are pricing in a full cut by then, followed by one more in December.

Services inflation fell in May but still surprised to the upside at 5.7% — driven by an acceleration in airfares and continued momentum in accommodation services. The latter may be a stumbling block to any August cut, as it is being driven by one night domestic stays, and that momentum could well continue as the Taylor Swift effect hits the UK shores. Her Eras Tour impact has been evident globally, most recently in Sweden as an example where core inflation rose in May to 2.3%, ending the run of disinflation. With 15 sold-out shows in the UK across June and August, reports have already arisen regarding spikes in hotel prices on these dates – including bespoke packages at the Four Seasons in Park Lane, whilst Barclays predict her UK leg will add £1bn to the UK economy. Maybe a more outlandish view, but not one to be discarded so easily, it could end up being a cruel summer for those on Threadneedle Street, but equally they may look through this as volatility.

Long-term rates have seen a general decline throughout June after a rollercoaster May, the softness however was driven by US data rather than domestic events. 5-year mid-market SONIA swaps trade back below 4%, but the curve from 5 to 10 years still appears anchored close to the 4% level for now.

Cameron Willard, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg.