Bank of England delivers a cautious hike

As was widely expected, the BoE hiked the Bank Rate by 25bp today to 0.75%. The committee voted 8-1 in favour of the hike with one dissenter preferring no change. This is a more dovish split than the four members voting in favour of a 50bp hike at the February meeting. The change seems to be motivated by the war in Ukraine, which is likely to accentuate both the near-term inflation peak (to around 8% in April, and potentially even higher later this year), but also its subsequent drop. Like in the previous meeting, the MPC said ‘some modest further tightening in monetary policy may be appropriate’ in the coming months but noted risks on both sides.

The UK economy is facing an energy shock that will dent disposable income

Regarding future moves, we have a fourth hike pencilled in for May but there is a good chance of a pause after that. One reason is that active gilt sales should begin after the Bank Rate reaches 1%, arguing for a more cautious hiking process as markets deal with the unprecedented policy. The other reason is growth. The UK economy is facing an energy shock that will dent disposable incomes. This has to be weighed against higher inflation. We expect it to peak at 8% in April. After that peak, we expect less pressure on the BoE to stay hawkish.

Our view of only one more hike this year contrasts with market expectations of five more hikes this year prior to today’s dovish surprise. We think this is excessive and expected some form of pushback from the committee. This has materialised in the form of the BoE signalling that inflation would fall below the 2% target within the forecast horizon premised on current market hike pricing. We expect the front-end to come down after today’s decision, as the market reassesses the BoE’s reaction function.

The committee didn’t update its policy on ‘passive' quantitative tightening, ie passive balance sheet reduction by not reinvesting the proceeds of gilts maturing in its existing portfolio. Neither did it mention active sales of gilts.

We expect 10Y sterling rates to tighten relative to their dollar peers

The inversion of the GBP swap curve is a sure sign that markets share our scepticism, even if most think the current inflation surge will require the BoE to tighten above what would be considered to be a neutral level for the economy. For now, gilt yields and swap rates are set to rise, alongside their developed market peers. Taking into account excessive market expectations for tightening, and a subdued economic outlook, we think we’re closer to the end of the adjustment higher in rates than to its start, and expect 10Y sterling rates to tighten relative to their dollar peers after the Fed showed it has far fewer qualms about tightening.

Sterling has sold off close to 1 % against the dollar after today’s cautiously dovish BoE hike. Going into the decision, GBP had been at its highs – perhaps fearing some further hawkish dissent from the consensus 25bp hike. Dissent arrived, but it turned out to be dovish with the BoE’s Jon Cunliffe understandably concerned about the impact on real incomes following another energy shock.

One standout is that the BoE is being far more cautious than the Fed last night. That is a reminder that the UK, like Europe, is an energy importer and more susceptible to events in Ukraine. With the US more exposed to demand-driven inflation, a confident Fed should keep the dollar in the ascendancy. We see a greater risk of GBP/USD trading 1.28 than 1.34 over the coming weeks.

Against the euro, however, GBP weakness should be more contained. This is the case because the same factors restraining BoE hawkishness will be playing out across continental Europe, too. And at least the BoE has already now delivered three hikes. We, therefore, see the EUR/GBP upside as more limited and do not see a strong case for it sustaining gains above the 0.8450/70 area. Indeed, focusing on a further BoE rate hike on 5 May, a time when UK CPI will be pushing to the 8% area, could see EUR/GBP trading back down to the 0.83 area.