Hawkish BOE budget twist may not be slam dunk :Mike Dolan
By Mike Dolan
LONDON, Nov 1 (Reuters) -Britain's pivotal tax, borrow and invest budget has elevated the Bank of England's interest rate horizon but sterling has hesitated and reversed - suggesting some think the BOE may well take a more nuanced view over the coming year.
BOE officials are currently in their traditional blackout period ahead of next Thursday's interest rate decision, so the central bank has had no immediate reaction to this week's budget.
But markets have already tweaked their forecasts after reading the runes of the UK fiscal plans and revised forecasts from the independent Office for Budget Responsibility, which show higher growth and inflation next year.
Not only are markets now pricing in at least one fewer UK rate cut next year than they had been, but they've even injected some doubt about whether there will be any easing next week.
Up until Wednesday, money markets appeared confident that the BOE would announce their second 25 basis point cut of the year next week, reducing the policy rate to 4.75%. The chances of this happening have since fallen to just 80%. And Goldman Sachs has broken with the pack and is now forecasting that the Bank will stay on hold at Thursday's meeting.
Moreover, implied market rates for the end of 2025 have risen to more than 4%. That's now half a point higher than the Fed equivalent in a year's time even though the two are little more than 10bps apart right now.
Five-year gilt yields GB5YT=RR are also higher than those of U.S. Treasuries - despite sharp pre-election increases stateside. And five-year gilts are some two percentage points above the German benchmarks EU5YT=RR.
The 18bps rise in two-year yields GB2YT=RR on Thursday was the largest one-day move since February.
Though this may reasonably show markets bracing for heavy new UK borrowing ahead, the market rush to revamp the BOE rate outlook looks less obvious.
While it's hard to read too much into global bond market moves mere days ahead of a potentially seismic U.S. presidential election, the pound's dour reaction to this week's big shifts in UK fiscal policy is notable.
Sterling GBP=, EURGBP= barely moved on budget day and has actually started to weaken against both the dollar and euro since then. This reflects either the re-emergence of a UK risk premium or contains doubts about whether the BOE will actually follow through on the markets' more hawkish rate projections.
RISK OR RETHINK
The arguments for a more hawkish BOE centre on the injection of new stimulus into the economy and higher inflation forecasts. The latter are fuelled by parallel hikes to the UK minimum wage and the risk that employers bearing the brunt of the new tax rises may try to recoup lost earnings with price rises.
With the BOE still wary of brisk wage and services price growth even as headline inflation has returned to target, many now feel that governor Andrew Bailey's recent suggestion for more "activist" monetary easing may need to be put on ice.
But there's good reason for the BOE to stick to its course.
The new OBR inflation forecast of 2.6% for next year is only one or two tenths higher than the BOE's standing forecast from its August Monetary Policy Report, which will be updated next week.
And the Bank may also be taking a longer-term view of the potential impact of the budget measures, which could prevent them from over-reacting.
In its review of the budget, the independent think tank National Institute of Economic and Social Research (NIESR) said the payroll tax increase on employers will hit job creation over time and likely cause the unemployment rate to rise.
"We expect significant negative impacts on employment and wage growth, especially in low-paid sectors such as hospitality," it said of the combined tax and minimum wage rises.
While the OBR forecasts that the UK will enjoy a real GDP growth bump to 2.0% next year, it expects this to fade thereafter, returning to 1.8% in 2026 and back to 1.5% in subsequent years. In such an environment, the government might struggle to fund higher borrowing unless there are deep interest rate cuts.
And even if the government's borrow-to-invest plan is successful and lifts UK potential growth from the meagre 1.5% now assumed, that should also increase the capacity for the economy to advance longer-term without causing a significant rise in inflation.
Giant global bond investor PIMCO said it continues to favour gilts even after the budget announcement, as it expects macro drivers such as softening inflation to quickly take over from fiscal concerns. "There are no reasons for us to question the fiscal credibility in the UK," said PIMCO economist Peder Beck-Friis.
A hawkish twist by the BOE may, therefore, not be as obvious as many assume - unless of course the pound does indeed take serious fright and complicates the whole picture even further.
The opinions expressed here are those of the author, a columnist for Reuters
US-UK 1-year rate spread vs sterling https://tmsnrt.rs/4fonMQo
The Day After for UK Rates and Pound https://tmsnrt.rs/4ectu6K
Hefty US yield premia vs G7, only UK higher https://tmsnrt.rs/40qAU36
Britain Autumn budget 2024 - Real GDP forecast https://reut.rs/4fpKMhT
UK public borrowing forecast to fall slower than in March https://reut.rs/3Uu0iBw
Where does the government expect to earn revenue from? https://reut.rs/3UwnLSl
BoE mulls second rate cut of the year next week after its first easing in 4 years in August https://reut.rs/3YuZoY2
Deutsche Bank charts on gilt and sterling budget reactions https://tmsnrt.rs/4fbL3oX
by Mike Dolan; Editing by Hugh Lawson
Related Assets
Latest News
Disclaimer: The XM Group entities provide execution-only service and access to our Online Trading Facility, permitting a person to view and/or use the content available on or via the website, is not intended to change or expand on this, nor does it change or expand on this. Such access and use are always subject to: (i) Terms and Conditions; (ii) Risk Warnings; and (iii) Full Disclaimer. Such content is therefore provided as no more than general information. Particularly, please be aware that the contents of our Online Trading Facility are neither a solicitation, nor an offer to enter any transactions on the financial markets. Trading on any financial market involves a significant level of risk to your capital.
All material published on our Online Trading Facility is intended for educational/informational purposes only, and does not contain – nor should it be considered as containing – financial, investment tax or trading advice and recommendations; or a record of our trading prices; or an offer of, or solicitation for, a transaction in any financial instruments; or unsolicited financial promotions to you.
Any third-party content, as well as content prepared by XM, such as: opinions, news, research, analyses, prices and other information or links to third-party sites contained on this website are provided on an “as-is” basis, as general market commentary, and do not constitute investment advice. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, it would be considered as marketing communication under the relevant laws and regulations. Please ensure that you have read and understood our Notification on Non-Independent Investment. Research and Risk Warning concerning the foregoing information, which can be accessed here.
