The last few weeks have been eventful for the United Kingdom. First, a spate of bad weather and sudden showers, followed shortly by political storms, as Foreign Secretary Boris Johnson reportedly raised the banners of rebellion before the PM’s widely anticipated speech in Florence. UK political complications have been developing at great speed leaving investors wondering whether a cliff-edge Brexit is drawing closer. The biggest surprise of all, however, came from the Bank of England and its Governor, the often enigmatic Mark Carney.
Last Thursday, minutes from the central bank’s rate setting body, the Monetary Policy Committee (MPC) indicated that the time has come for the first interest rate hike in more than a decade. The Pound jumped close to its highest post-referendum levels on the news, and expectations for a rate rise this year rose to 73%, up from 20% in June. Three days later, the Governor doubled down, saying that any interest rate hike would respond to post-Brexit wage pressures in the face of labour shortages. He added that hikes would be “limited and gradual” but that did little to affect markets, who are already pricing in one and possibly a series of rate hikes.
Investors have been slightly blindsided by the BoE’s newfound hawkishness. Unlike the US which is normalising rates, the UK economy which traditionally trails American monetary policy, is now at a very different part of the cycle. The running assumption had been that interest rates would remain at or near record-low levels until markets achieve higher levels of certainty over what post-Brexit Britain will look like. At the very most, economists were expecting a single quarter percent rate hike, to signal the end of the extraordinary measures taken after the referendum.
However the story Mr. Carney and his colleagues gave markets was quite different. The board members suggested a series of hikes rather than one, clearly identifying the dangers of wage inflation as companies struggle to find skilled workers.
We believe that it’s still early to be talking about a rate hike cycle or normalisation, despite Mr. Carney’s recent communications. Raising the cost of money is considered a standard solution to fight domestic inflation but it has often been noted that interest rates are a blunt policy tool. GDP has slowed from 2.2% to 1.7%, and in a recent report the OECD estimated that real growth for 2018 will be profoundly anaemic, just 1%. While the market now is at full employment the effects of Brexit on the financial sector, which accounts for 20% of output, are yet to be felt, so those wage pressures might not be so pronounced.
Central bankers have often resorted to verbal hawkishness, “talking” interest rates higher than they were prepared to raise them. It is possible that the central bank tries to warn markets not to bet too heavily against the Pound, without breaking its pledge to steer clear from currency interventions. After all, the weaker currency bears the risk of external inflation, against which there’s little an economy can do.
Or it is indeed possible that the recent green patch of macroeconomic data has increased the confidence of the board to consider less “extraordinary” and more “normal” measures to implement policy decisions and foster a stable inflation environment?
We have seen many false starts in the normalisation of interest rates since the Global Financial Crisis, and the Governor’s habit of not necessarily following words with actions causes us to question whether recent comments should be taken at face value. Nonetheless, we remain significantly underweight Gilts given our assessment that the risks still considerably outweigh the possible returns.
Fears and Flows 