Chancellor fiscally constrained; MPC makes slight 'dovish pivot'

January’s GDP figures would suggest that the UK has emerged out a shallow recession, yet this did not change the very difficult fiscal backdrop facing Chancellor Jeremy Hunt at the March Budget. He had limited fiscal room to cut taxes in a general election year, and as a result, there was very little announced that had not already been publicised across the media in advance. Incidentally, had Hunt been delivering his statement two or three months ago, he would have had quite a bit more room to cut taxes. Ten year government borrowing costs dropped as low as 3.5% at the end of December 2023, but as market expectations for rate cuts started to dial back ten year gilt yields edged back up to around their current level of 4% (see Figure 2 within A view from the dealing desk). 

The government will no doubt hope that the medium-term inflation outlook improves over the next few months, potentially reducing borrowing costs and perhaps allowing for one further fiscal event before a general election. After the Budget, we thought Opens in a new window that this would probably mean an autumn election rather than a May election, something the Prime Minister appears to have subsequently confirmed Opens in a new window. 

So, what is the current state of play when it comes to the inflation outlook and the prospect of rate cuts? March’s Monetary Policy Committee (MPC) meeting gave us a clue. The voting breakdown indicates a slight “dovish pivot”: the two members voting for a hike in rates in February are now with the majority voting for a freeze in rates. However, the Bank of England’s (BoE’s) overall position remains pretty much unchanged: the MPC will continue to monitor for persistent signs of inflation and review how long Bank Rate should stay at 5.25%. While inflation is expected to meet the 2% inflation target in just a few months’ time, the majority of MPC members need to see further evidence that it can stay at the BoE’s target in the medium term sustainably. In particular, further evidence of cooling nominal wage growth and services inflation is required, although interestingly the minutes of the meeting would suggest there is disagreement among the committee of exactly how much evidence is needed before they can start voting for rate cuts.  

Bank of England Governor Andrew Bailey last week clearly indicated that interest rate cuts are "in play" this year. We remain of the view that there are likely to be three rate cuts this year, with the first taking place in the summer. This is a view supported by current market expectations. 

UK view

Since February’s Rate Wrap, the UK Chancellor Jeremy Hunt has unveiled his spring Budget which caused little excitement in markets, with the majority of announcements in line with what the press and markets had expected. The element of surprise is of little favour these days since the Liz Truss and Kwasi Kwarteng Budget, and the minimal impact of the tax cuts is unlikely to tempt the MPC into changing gears too quickly. Gilt yields since the start of January are up just shy of 50bps, leaving little wiggle room for much fiscal stimulus to be exercised, and this was little changed following the Budget as Daniel has touched upon in more depth above. There was a c.5bp reduction in longer-term gilt yields on Budget day, but the Budget itself had little suspected impact on this. The driver in gilt yield movements has been  attributed more to Jerome Powell’s dovish tones compared to other fellow FOMC speakers and market expectations off the back of this for when the US is expected to cut rates. The US in many cases is seen as a “trend setter” for market expectations. 

Inflation has continued to soften, with the February CPI figure coming in at 3.4%, below consensus and the MPC’s forecast of 3.5%. While largely owing to base effects and the 12% fall in household energy bills due in April, there has been a trend over the past few months of a downward trajectory for food and non-alcoholic beverages and restaurants and hotel. It is widely anticipated that headline figures should be below 2% in either April or May, and this will give the MPC some leeway for more solid consideration of rate cuts. Labour Force Survey data reliability remains a bone of contention for the MPC and its holistic view of whether rate cuts can be considered yet, and so the largely unchanged quarter-on-quarter unemployment figures out early March should be viewed with caution. 

The surprise fall to February’s CPI figure is a welcome surprise to the MPC, but as widely anticipated the MPC voted to hold rates at 5.25% at the March meeting. Hawkish members Catherine Mann and Jonathan Haskel pivoted on their usual stance to vote for a hike to join an 8-1 majority to hold rates. Swati Dhingra continued in dovish fashion for a second meeting in a row to vote for a 0.25% cut. As ever the devil is in the detail in the rhetoric that follows, and the narrative for the Bank of England is continuing to shift toward loosening policy. One of the biggest focal points is the guidance published after the meeting, with additional guidance added that “monetary policy could remain restrictive even if Bank Rate were to be reduced”. This demonstrates a reframing of what restrictive policy means, which chief economist Huw Pill has been hinting at for some time now, that the MPC is gaining confidence that loosening of policy via rate cuts could soon be on the cards. Bonds rallied in the wake of the meeting, with 2-year yields on UK gilts falling 14bps, the largest dovish tilt move in over a month. Across the curve we’re seeing some run-off in yields again as the curve looks to adjust to the anticipated rate cut backdrop. See Figure 2 below. 

In the wake of the MPC meeting, market-implied SONIA rates are now torn between whether there will be a 75bp – 100bp cut by the end of the year. Market-implied pricing suggests there is a chance of 3 cuts still by the end of December which will take us to a Base Rate of 4.50%, remaining in line with Handelsbanken’s forecast. However, since the March MPC meeting, the chances of a June cut have now risen, with an 84% chance of a cut now priced in for June.  

Jasmine Crabb, Capital Markets

US view

On Weds 20th US Federal Reserve officials voted unanimously to keep the benchmark federal funds rate on hold in a range of 5.25-5.50% for a fifth straight meeting. With the recent February CPI data showing a buildup in inflationary pressures, up to 3.15% year-on-year from 3.09% in January, this was very much expected and fully priced in by the market.

More notable was the Fed’s updated version of the dot plot, their forecast of future interest rates, showing a revision upwards to keep rates high for longer in the short-term and stabilising at higher levels in the longer term to help combat their revised upwards inflation forecast. The guidance now is for the Fed Funds lower bound to be cut three times in the second half of this year, starting in July, to reach 4.50%, then three further cuts in 2025 and 2026 each – nine cuts in total, and down from the ten that had previously been forecast. The median dot now suggests that US rates will settle at 2.6% in the longer term, up from the 2.5% previously indicated.

The dot plot managed to hold traders attention for roughly 45 minutes before Chairman Jerome Powell responded to a question from the Wall Street Journal that the two recent months of sticky inflation data “haven’t really changed the overall story, which is that of inflation moving down gradually on a sometimes bumpy road toward 2%.”  Treasury yields had whipsawed initially on the dot plot news but now softened, with the 2-year rate shaving c.7 basis points to 4.50% and the 5-year a similar amount to 4.25%, whilst 10-year yields returned more or less to their original level of 4.27%. It is worth noting the normalisation of 5-10 year spreads showing the expectation for rates to remain steady in the medium to long term.

Diving a little deeper in to the key drivers of the February CPI print paints a fuller picture: prices of both energy (-0.13%) and core goods (-0.08%) actually fell on an annual basis and were disinflationary. The key driver remains service costs, making up circa 3.06% of the total 3.15% February headline print. Indeed 1.98% was put down to household rent alone, a cost that typically wouldn’t see sizable consecutive annual rises if interest rates aren’t rising and so is reasonable to expect to slow. How this develops will be crucial to the timing of the first interest rate cut, and the March CPI data due for release on April 10 will be the next key release to watch.

Tom Barker, Capital Markets