Mullet hiking cycle

After the turbulence following the so-called “mini-Budget” in September and the subsequent downfall of the former Prime Minister Liz Truss, the reaction of financial markets to the Autumn Statement on 17 November will have been at the forefront of government ministers’ minds. The government will have felt a sense of relief on this front: market expectations for interest rates and yields on gilts barely moved following the statement. But while achieving short-term financial market stability was a critically important objective, the overall package of measures remains controversial. The £55bn of fiscal tightening has been announced just as the economy is moving into recession. 

This fiscal consolidation is somewhat different to that pursued in the early 2010s. The scale of the tightening is not as large and the composition is different with tax rises doing more of the tightening this time around. And of the spending restraint that was announced, a large chunk has been postponed until after the next general election – for example, lowering the growth of departmental spending across Whitehall will only start to kick- in from 2025-26. 

The economic backdrop to this Budget was gloomy, with the UK facing the dual problem of high inflation and a slowing economy. In the UK, multiple indicators were already flashing red with consumer confidence registering at record lows and business PMIs indicating contraction of both the services and manufacturing sectors. You would see a similar picture in many other Western economies although the UK faces its own unique challenges, not least with its labour market. The growth in inactivity rates is an especially concerning problem given that this has been observed much more strongly in the UK compared to many of its G7 counterparts. The UK has also, of course, suffered from a slowdown in trade due to bureaucratic burdens associated with Brexit.

While some of the constraint on spending has been deferred, the fiscal statement imposes some short-term measures that will affect consumer spending during the impending downturn. Alongside tax policies that will eat into pay packets – such as the freezing of various tax thresholds – the government is committed to a much less generous energy price guarantee from April 2023, with a the energy cap due to be lifted by 20% along with the removal of £400 support for households. This could mean that the UK ends up facing a deeper recession than many of its counterparts: it is notable that other major western economies are yet to announce a withdrawal of energy price support so soon.

Without the benefit of a positive external shock – for example, a cessation of the war in Ukraine – the UK economy is in for a difficult twelve to eighteen months. Some of the projections from the Office for Budget Responsibility are really quite striking. For example, real household disposable income is due to fall 4.3% in 2022-23, which would be the biggest drop on record.

The Bank of England now has a tricky balancing act between suppressing any signs of domestically-led inflationary pressures and ensuring that the downturn is not unnecessarily protracted, while also of course being on guard for any financial stability risks that could come about from the upcoming correction in the property market. At the time of writing, market expectations are for interest rates to peak at around 4.5%; we remain of the view that rates will peak somewhat below this at around 4% as the Bank of England weighs up all of the considerations.  

Daniel Mahoney, UK Economist

We on the desk can give ourselves a pat on the back in relation to the latest Federal Reserve and Bank of England meetings, where our calls on how it would all play out were broadly correct.

Starting with the Fed, as a recap, the market had been hoping for some form of ‘pivot’ from the central bank, expressing concern around the economy and therefore softening the tone towards the pace of upcoming rate hikes and ultimately where the terminal rate lies. In the last Rate Wrap, I mentioned how I was slightly sceptical of this, given that official data was at least still topping estimates, and the Fed wants to ensure that conditions remain tight in order for its efforts to be rewarded – talk of a pivot allowed market rates to fall and equities to rise, effectively the opposite of what the Fed wants to see

In terms of the actual decision, there was no surprise that the Fed Funds band was raised again by 0.75%, taking the upper band to 4%. The changes in the statement initially boosted those hoping for such a pivot, where an additional line was added stating that “the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments”. This suggested that the Fed had done the majority of the leg work already in fighting inflation, and now perhaps more weight will be placed on “economic and financial developments”. Considering both have deteriorated, markets concluded that this is the signal that the pace of rate hikes will slow. This was later backed up by the Fed Chair Jay Powell himself where he said the pace of hikes could slow as soon as the next meeting in December.

The initial dovish reaction, namely lower yields and weaker dollar, was soon reversed. Jay Powell, rather sensibly in my eyes, shifted the narrative away from the pace of upcoming rate hikes (which was always going to happen, continuous 0.75% rises is not sustainable) to where the terminal, or peak, rate will lie. On this point, Mr Powell noted that “ultimate level of interest rates will be higher than previously expected”. Putting numbers on this, the previous Fed forecast was for the Fed Funds to peak between 4.50-4.75%, which suggests therefore that the Fed now sees the peak at 5% or above, thus even exceeding market expectations which were around 5% heading into the meeting. This surprised the market, and proved to be the key takeaway of the meeting, with yields reversing higher and the dollar trading stronger as a result. 

What is clear is that the Fed is working through a “mullet cycle”, a short quick-fire rise in rates to start with, followed by a longer period of gradual hikes towards the end before hitting its peak. The desk expected this sort of caveat from Mr Powell, and even though we favour a 50bp hike in December, an extended cycle of hikes cannot be ruled out especially if data remains strong. November US nonfarm payrolls grew by 261k in October, again beating estimates, from an upwardly revised 315k in September. 

However the market view changed dramatically following October’s consumer price inflation release which softened more than expected. The monthly core rate rose just 0.3% from 0.5% expected, whilst the annual rate fell to 6.3%. The headline rate also fell markedly to 7.7%, and the subsequent producer price inflation release also missed estimates. The market reaction was bold, equities storming, the dollar losing 4% on the week, and rates plummeting. The US 10 -year yield now sits at 3.8% from 4.10% pre the CPI report. Responses from the Fed have been slightly varied, with Christopher Waller noting that this is only one release, and that there is “still a ways to go”, although Leal Brainard noted that the pace of rate hikes should “soon” slow.

Around 20bps had been shaved off of market expectations taking the terminal rate under 5% again, not insignificant, but the flatness of the curve remained. This gives me hope that the market acknowledges that this is only one data release, and it does not yet mark a trend. 50bps looks nailed on now for December, more questions remain over the future rate path but this will be data dependant. I would still angle for a peak at 5%, and index expectations have gravitated back towards this mark after comments from hawk James Bullard, but that might be different when we come to write December’s wrap with another inflation print to hand!

Another dovish BoE hike

Going into the November 3 Bank of England meeting, we thought we would see a 75bp hike in a split 7-2 decision, whilst the supporting commentary would again push back against the market path for rates. Breaking down further, we saw the two dissenters being Silvana Tenreyro and Swati Dhingra, voting for a 50bp hike only.

Well, we nearly nailed it. The BoE did decide to raise Bank Rate by 0.75%, taking the rate to 3% - the highest since 2008. The markets were more or less discounting a 75bp hike, pricing in about 70bp of hikes before the meeting, although that had fallen considerably from as high as 150bps during the mini-budget chaos. Given all the talk around a pivot following moves from the central banks of Canada and Australia, alongside the rather dismal outlook for the UK, some forecasters were angling for a smaller hike too. However, back in October on a panel in Washington, Governor Andrew Bailey warned that a “stronger” response than previously anticipated could be required to tackle inflation. Even with the political mayhem subsiding before the decision, we expected the MPC to follow up on this communication – especially with the Fed and European Central Bank opting for a 75bp rise.

On the vote split, it was 7-2  as we expected with Ms Tenreyro and Ms Dhingra dissenting. However the only difference to our prediction was the decision of Silvana Tenreyro to opt for, a 25bp hike only.

Despite the biggest hike for three decades, the decision was again rather dovish. The central bank could not be any more clear in their disagreement with the market on the rate path, explicitly mentioning this in the statement where it noted that a majority of members now think that 

 “further increases in bank rate might be required for a sustainable return of inflation to target, albeit to a peak lower than priced into financial markets”. This has been echoed in subsequent comments from Andrew Bailey, Chief Economist Huw Pill and Catherine Mann. We knew this shift was coming following MPC member Ben Broadbent’s comments in October where he suggested that bank rate at 5% could knock as much as 5% off GDP. Inflation forecasts continue to support this, signalling that inflation would fall to 1.4%, below target, in 2 years’ time if the market path is correct. On the flipside, with rates staying at 3%, inflation would fall to 2.2%, implying that further hikes are needed.

So how did the market react? If you are a regular reader you can probably guess, rather stubbornly. Yields and swap rates did fall, but by not as much as one would expect. Looking at short term OIS rates, we have only seen about 10bps shaved off the expected peak in June next year – now seen between 4.50 and 4.75%. This is another illustration of the market’s, doubts, or lack of trust in the MPC to deliver what it says. It will not be solely down to this, pressure from hawkish peers in the US and Europe, plus liquidity in these markets will also play a part, nevertheless it speaks volumes that a message this clear is quite simply ignored.

You can see the latest pricing both in the short- term and long- term via swaps below. These swaps imply potentially two interest rate cuts in 2024, but after that it is expected to remain flat around 4% for the following few years.

The full budget, pushed back to November 17 had fallen into the shadows somewhat after the appointment of Jeremy Hunt as Chancellor and subsequently Rishi Sunak as Prime Minister. This is not surprising for a couple of reasons;: one being the focus shifting to the Bank of England meeting and interest rates generally, and the other being that it is well known what the direction of travel will be when it comes to the budget – namely tighter policy through spending cuts and tax rises.

This ultimately was reflected in the fairly sanguine change in rates in the aftermath of the budget. I had a slight concern that there may be a negative reaction to the back-loaded spending cuts (coming in after the next election) and the looser fiscal targets, which is now set over a 5 -year horizon rather than over 3, but the uplift in yields was minimal – the 10 -year gilt rose only by 5-6 basis points to over 3.2%.

The gilt market no longer looks on a fragile footing, indeed it seemingly got its wish in Luiz Truss’ resignation. LDI funds are in better shape, and furthermore the Bank of England completed its first active sale of bonds held on the balance sheet which was well -received. The central bank is rightly proceeding cautiously, selling £750m worth of assets which had shorter maturities. The sales generated bids of £2.44bn, of which 40% of that demand was for one scarce bond maturing in 2026 (this is relevant due to ongoing problems in the repo market, the plumbing of the financial system, where there is a lack of eligible bonds available for collateral). The second sale the following week was not as successful, however the securities on sale were for longer maturities, and as highlighted above they are not the notes in demand. Asset sales are set to continue at a pace of £10bn a quarter, alongside passive sales (bonds maturing and not reinvested - the next passive sale is not due until next June). 

Hedging dilemmas

There is perhaps no surprise the desks are as busy as ever, having discussions with customers around the market, potential scenarios, which leads to the question as to whether now is a good time to hedge. It is apparent that we may have reached an inflection point, are we at the peak for market rates? Will they wake up and smell the Bank of England’s (rather cold) coffee?

It’s impossible to say, outside a lack of trust we need to consider other factors that may keep rates elevated, in particular what other central banks do, as discussed above. The Fed and ECB, expected to go to 5% and 3% respectively, will keep the market cautious. We still cannot ignore the energy story either, especially with the uncertainty on what the government decides to do with the support programme post April next year. We have mentioned in this column as well as our daily commentary on multiple occasions that the gas prices, whilst way off its highs, is still three times higher than the average for the time of year, and have potential to accelerate higher next year when Russia’s supply inevitably disappears.

We are not advisors, but one thing we always point out to customers is that debating whether it’s the right time is subjective. With the benefit of hindsight there will always be a better time to do it, and it’s not about competing against the market, it’s whether it’s right for the business at that point in time. In a world full of uncertainties, more so than ever, hedging via derivatives or standard fixed rate products provide an avenue to control one of these unknowns. In the end it comes down to what price a business is willing to pay for certainty.

This is why we still see mixed interest in both swaps/fixed rates and interest rate caps. It is noteworthy that cap costs have come off the highs as volatility has subsided somewhat, but remain elevated relative to earlier this year. As rates creep higher we are seeing greater interest in collars too, a product whereby a customer buys a cap, and simultaneously sells a floor in order to offset part or all of the cost of the cap.

Cameron Willard, Capital Markets

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