Bank of England's 5th November release turns into a cracker

10 November 2015

Another week of encouraging economic data, another week with stock markets struggling to make up their mind whether that’s good news or not good news. The bond markets, on the other hand, appear to have received the message: The economy is continuing on its gradual expansion path, which means rate rises will become inevitable and, more importantly, better return can be had elsewhere. As a consequence, we witnessed a marked sell-off in short maturity bonds. Their yield movement can be interpreted as the bond markets’ barometer for short term economic change expectations. If yields fall, bond investors see trouble ahead. If they rise, things are looking rosier. Rise they did (note the inverse relationship between yield and bond value movements), indicating that they are receiving the message from both the improving economic data flow and the continuous messaging from the major central banks. Those central banks provided the other big news stories of the past week. First, Janet Yellen of the US central bank, the Federal Reserve (Fed), confirmed the previous week’s impression that a December rate rise for the US was, in her words, “a live possibility”. Stock markets took it once again relatively relaxed, although that may have also been because two other big central banks were at pains to reassure them that they would either consider to do the opposite in their December meeting or at least not follow suit for some considerable time. The former was the European Central Bank (ECB) and the latter our Bank of England (BoE). Mark Carney, the BoE governor, seemed almost desperate to distance the UK’s monetary policy direction from that just reiterated by the Fed. In the press conference to present the month’s inflation report and rates decision, he pointed out that, as far as inflation expectations for the medium term are concerned, there is no immediate requirement for a rate rise until 2017(!). What we had expected to be a boring announcement of a continuation of the same low 0.5% interest rate, suddenly turned into a bit of a fire-cracker (sorry for the pun, but it was the 5th of November). To be sure, he didn’t actually say that the MPC would not raise rates before 2017, but it was nevertheless very clear to all informed observers that this was a strong message that markets should not assume the UK would quickly follow the US with raising rates. The reason, in my opinion, is not so much that this would be overly detrimental to the UK economy because of (marginally) increased cost of finance, but rather that those economic areas that raise rates first tend to experience a surge in the value of their currency. This not only disadvantages their exporters (because their goods become more expensive in other currencies), but also brings down import prices (the reverse effect). With the UK currently experiencing near 0% inflation, this is not something Carney would appreciate. Sadly for the BoE, the markets seemed to sense the ruse. Sterling fell a little, but by no means as much as it had risen in recent weeks. We still expect the first UK rate rise during 2016, as otherwise there is a real risk of asset bubbles forming. These seem to have become the modern day equivalent of old style inflation, i.e. a dangerous reaction to monetary policy which is too loose versus (most) of the prevailing state of the economy. The UK’s main bubble potential is in residential property price inflation. Higher interest rates would most certainly reduce the upward pressure which, as also reported over the week, continues to run at 10% p.a. We suspect that the BoE will, for the time being, adopt a ‘wait and see’ stance, until it becomes clearer how much of the upward pressure on the currency has already been anticipated by markets. At that point, a decision will need be made on which the lesser evil will be: House price controls via mortgage lending restrictions (macro prudential instruments), or a gradual onset of rate rises which put downward pressures on exporters and inflation.