BoE guides for year-end rate hike - Bluff or real?

15 September 2017

This week's cartoon depicts aptly how roughly half of the UK's economists and market commentators chose to interpret the Bank of England's (BoE) formal warning that there may well be a rate hike before the end of this year. Not at the end of 2018 as the markets had up to now priced in, on the back of the weakening economic environment due to the Brexit uncertainties.

To make sense of what is going on, we need to acknowledge the predicament the BoE's rate setting committee members face. On the one hand, weak business investment and inflation squeezed consumers are hampering the UK's economy to the point where in growth terms the rest of Europe is suddenly overtaking. This would call for more economic stimulus, i.e. low rates for longer.

On the other hand, the UK's current inflation issue is almost entirely caused by the weakness of £'‘Sterling and the price rising effect this has on all imported goods and services. The BoE is explicitly tasked with guarding the UK's price stability. The prospect of higher interest rates usually strengthens a currency - this would call for raising interest rates.

With unemployment continuing to fall to lows last seen 40 years ago, and the combination of low rates and improved job security tempting consumers to take on more (credit card) debt than may be good for them once rates do rise, the BoE can also point at further good reasons to raise rates sooner rather than later.

The ideal scenario would be where the central bank could create the expectation of rate rises which strengthens the currency but doesn't actually have to raise rates which may still be harmful for the wider economy. On the face of it the BoE succeeded in achieving exactly that this week - despite all the talk that they are bluffing.

In our opinion this was mainly achieved by one of their most academically astute external committee members - Gertjan Vlieghe - in a speech presenting a cohesive argument why rate rises may be necessary now and at the same time not become an issue for the economy (more on the subject in the second article of this week's edition).

Nevertheless, the BoE's credibility is now at stake and if rates do not rise before the end of the year, then £-Sterling will plummet again. We therefore believe it highly likely now that we will get a 0.25% rate rise this year. However, this would simply return UK interest rates back to where they already were for nearly 8 years, prior to last year's referendum (see chart below).

Thereafter, further rate rises will once again be very dependent on the shape of the UK economy. To this end, we would not be surprised if the economists at the BoE are putting their hope into the same charts we have peered over during this week's investment committee. They are telling us that there is a good chance that the UK's economy will at long last come to enjoy a demand boost from export growth, as the weakness of £-Sterling is finally leading to a marked improvement in order books.

In other news this week, we were initially very relieved that the North Korean Kim Jong-un refrained from missile '˜fireworks' to commemorate the country's founding day. We were perhaps even more relieved when markets almost ignored on Thursday the firing of a mid-range test missile that flew over Japan and then fell into the Pacific. It appears that '˜missile fatigue' has set in and led to stress relief in markets, with bonds losing ground and equities gaining. Only in the UK both asset classes lost value over the week, but this was a straight reversal of what investors enjoyed last year when £-Sterling's depreciation led to rallying stock markets, as overseas revenue streams become more valuable and overseas investors snapped up shares that had become bargains from an external currency perspective.

The UK equity underweight across portfolios added value in this environment, but the £-Sterling underweight this brings needs to be continuously assessed. With the Global economic outlook consistently improving and even the US president finally beginning to achieve policy progress we are minded to raise portfolio equity allocations from underweight back to neutral. Higher than benchmark/risk-profile neutral still does not look like the right positioning as long as the North Korea conflict remains unresolved and thereby might or might not deteriorate investor sentiment rapidly. However, on the basis of its unpredictability it appears wrong to position portfolios in anticipation of an event that might never happen.

For the full weekly, please click here.