As investors try to calibrate which central bank will tighten policy next, the uncertainty over the country’s divorce negotiations with the EU has pushed the Bank of England towards the back of the pack.
A weaker pound and a two-year gilt yield dipping below the BoE’s current base rate of 0.25 per cent was the immediate market reaction on Wednesday after the central bank’s latest meeting saw it keep rates unchanged and cut its growth forecasts for the UK.
The pound and gilts market were swept up in the reverberations across markets in late June when a gathering of central bankers in the Portuguese resort of Sintra had investors anticipating a co-ordinated move towards less easy policy. Now, the mood for investors is very different for traders looking at UK markets.
“If you go back six weeks ago, the market was having to price a risk of a rate hike this year,” says Thomas Sartain, a fund manager at Schroders. “That probability had gone up quite significantly,” he added. “As the data’s come out a bit softer . . . those odds have gone down, hence the reaction today”.
Expectations for the first full 25 basis point rate rise have been pushed back to December of 2018, according to analysts at RBC Capital Markets. Before the Monetary Policy Committee’s meeting this week, August had been pencilled in as the first rate rise.
The challenge for investors now is how to interpret the central bank’s latest message. Aside from the question of when a rate rise may occur, one central complication is the role of Brexit, which Mark Carney, the BoE governor, pointed to repeatedly in his meeting as having weakened the pound and increased inflation.
“We have been operating in exceptional circumstances, we will be for some time, because of the extraordinary nature of the Brexit process,” he said at a press conference following the release of the BoE’s quarterly Inflation Report.
Investors in UK government and corporate bonds have already originally benefited from the central bank’s response to Brexit, when it cut the key interest rate to its current, record-low level of 0.25 per cent. Additional purchases of gilts helped pull bond yields lower and boosted their prices. The Bank also bought £10bn of corporate bonds, igniting a strong performance for the sector.
More than a year on from the vote, there is a sense in which Brexit is continuing to support sterling fixed-income markets by encouraging caution among policymakers.
“Ordinarily during an economic cycle you’d expect US and UK economies to be relatively co-ordinated in terms of where they are in the economic cycle,” says David Hollis, a multi-asset portfolio manager at Allianz Global Investors. “The key with the UK is Brexit is clearly an uncertainty and that’s why they’re not necessarily in a hurry to raise rates,” he added.
The process of leaving the EU has also severely weakened the pound against the euro. Sterling fell to its lowest level against the euro in nine months on Thursday. In turn, the two-year gilt dropped to 0.21 per cent, extending a drop from its post-Brexit referendum peak of 0.35 per cent seen in late June.
Neil Mellor, senior currency strategist at BNY Mellon, noted after the meeting that the currency was due a hit after June’s meeting when the MPC split 5-3 in favour of holding rates. This week the split was 6-2.
“Ahead of the report, we felt that GBP was living on borrowed time — borrowed from the split in June’s vote that we felt, and still feel, probably constituted ‘peak-hawk’ on the MPC in 2017,” he noted.
Still, the Bank of England’s language, while down from “peak-hawk”, was not straightforwardly dovish, despite the market reaction. “If the economy follows a path broadly consistent with the August central projections, then monetary policy could need to be tightened by a somewhat greater extent over the forecast period than the path implied by the yield curve underlying the August projections,” it said in its statement.
Analysts at RBC Capital Markets suggested that the market is “not sure” about the MPC’s conclusion on rates, arguing that investors reacted with scepticism to any optimism in its BoE forecasts, and that it is “more willing to put weight on the weaker near-term outlook”.
Another way of reading that assessment is that market participants are concerned over the extent to which Brexit could complicate economic forecasts. Marc Chandler, global head of currency strategy at Brown Brothers Harriman, notes that the BoE is currently forecasting a smooth exit from the EU.
The UK, grappling with the complications and uncertainties around leaving the European Union, suddenly seems distanced from broader shifts in global monetary policy. Investors say Brexit has helped distance its central bankers from the Sintra shift earlier this summer.
“The overwhelming risk for the Bank of England is one where a premature rate hike slows the economy, potentially weakening the pound, with activity data soft, real wages stretched and Brexit uncertainty high,” says Ben Edwards, a fixed income manager at BlackRock. “A ‘normalisation’ of policy on this side of the Atlantic seems very far off indeed”.