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Investors weigh Brexit against risks of a hawkish Carney

Mark Carney has form when it comes to prematurely warning investors about possible changes in interest rates. The Bank of England governor got tagged as “the boy who cried wolf” just over two years ago when he floated the idea of a rate rise only to backtrack.

A similar pattern was seen more recently. “We’ve seen a bit of a false start before from Carney who sounded relatively hawkish at one stage early in the year before dialling that back as we headed into summertime,” says Brad Bechtel at Jefferies International.

So it is hardly surprising if investors view any rhetoric from the BoE pointing towards a tightening in policy with caution. True, UK inflation is running ahead of target, and unemployment is at another record low — data that other developed countries seeking to move away from zero-bound policy might envy.

On paper, this may point to Mr Carney and his colleagues on the Monetary Policy Committee raising rates on Thursday for the first time in a decade.

Investors and traders are giving that possibility some consideration. The pound jumped 0.9 per cent against the dollar to a 12-month high on Tuesday, and also leapt against the euro after inflation figures for August topped forecasts.

“Against this backdrop, it’s Carney’s move now,” says Mr Bechtel.

Yet markets have been reluctant to bite. Hawkish talk from the MPC has been in the ear of investors at various times this year, notably in June when three members of the committee voted to raise rates. But there are plenty of investors who still don’t expect the bank to raise rates until 2019.

That stubborn view convinces Mr Carney and some of his colleagues that the markets and the country at large have developed a blind spot on interest rates.

In light of this week’s inflation bump, rate expectations, as well as sterling, duly ticked up.

The probability of a rise this year approached one-third after annual headline inflation climbed to a four-year high of 2.9 per cent. Prices for gilts slid, with the yield on the two-year government bond rising to 0.29 per cent for the first time since August 3 and back above the BoE’s current base rate of 0.25 per cent.

Even with the inflation rise, scepticism about the BoE raising borrowing costs is not hard to find.

“Given the inherent scope of month-to-month price changes to cause volatility in the annual inflation rate, it is not clear that, by itself, this upside news will sway any MPC votes this time around,” says Sam Hill, RBC Capital Markets economist.

Equally, economists at Bank of America Merrill Lynch say UK growth is “underwhelming and risks high”, pointing to a malaise in car sales and ebbing consumer confidence.

And while the unemployment rate is a plus for the hawks on the MPC, the accompanying data on wages disappointed, taking some of the gloss off the rise in sterling and gilts earlier in the week.

Analysts’ prevailing view is for the MPC to hold rates on Thursday, while shifting the dial towards those seeking a rate rise. Analysts at BofA ML are sticking to their prediction of 2019 for the BoE to move rates higher, but acknowledge the risk of an earlier move.

After the MPC voted 6-2 in favour of holding rates in August — when the committee was one member short — the balance may move to 6-3 on Thursday, some analysts believe. Such a shift would likely support sterling and weigh further on the price for two-year gilts.

Investors must weigh up all of this even before addressing the vexed issue of Brexit. Roger Hallam, of JPMorgan Asset Management, says that the MPC would rather not have to consider a rate rise simply because of Brexit uncertainty.

It is fine to look at reasons for hawkishness, such as the limited spare capacity in the economy and an inflation rate staying above target into 2019, adds Mr Hill, but “slow progress with Brexit negotiations poses risks to confidence”.

So any fresh BoE hawkishness may lead to only a shortlived appreciation for sterling. The pound may get a mere “one-time boost”, says ING’s Viraj Patel, before it falls to Brexit to “recapture the narrative” ahead of an important few weeks in UK politics and EU negotiations.

Kathleen Brooks, at City Index, sees Brexit in a different context. Arguing the case for the BoE to normalise monetary policy ahead of the European Central Bank, she says: “While the UK economy has been subdued, Brexit uncertainty hasn’t triggered a sharp economic downturn and business investment is still holding up well.”

She also spies a turn in wage growth, following the removal of the public sector pay cap and the emergence of worker shortages in some sectors.

For investors and policymakers alike, Brexit and its impact on the economy remains the big unknown quantity. Until that becomes clearer, the market and the Bank of England may have no choice but to sit and wait.