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Market Update

Bailey enacts biggest rate rise since 1995

August 4, 2022


On August 4, the Bank of England (BoE) voted eight-to-one to raise the U.K. base rate by 0.50% to 1.75%, with the lone dissenter voting in favour of a more modest 0.25% hike. This was the sixth straight hike by the BoE and the first 0.50% hike since it became independent from the U.K. government in 1997. The market is continuing to price in a year-end SONIA rate of 2.75%, in line with pre-announcement expectations, and a peak of 3.00% in March 2023. Coming into this Monetary Policy Committee (MPC) meeting, the market had priced in the likelihood of a 50 bps hike at 80%. Following the press release 2-year GBP swap rate fell 9 bps to 2.65%, the 5-year fell 7 bps to 2.30%, and the 10-year fell 4 bps to 2.05%.

Fears for a recession are rising, and this is what impacted the swap market. Sterling sold off 90 pips to trade at 1.2099 against the U.S. dollar by 12:30 UKT. The downward move in GBP swap rates reflects the market’s concern that the BoE’s current rate regime will lead the U.K. into a recession. Such sentiment was not helped by the minutes that retained language to act "forcefully" against inflation, but this came with a caveat that their policy is "not on a pre-set path". As suggested by BoE Governor Andrew Bailey in July, the MPC discussed beginning quantitative tightening by selling gilts held in their Asset Purchase Facility (APF). This is expected to begin in September with target to sell GBP 40B along with a further GBP 40B which is expected to roll of the balance sheet within the first year. The gilt selling programme is expected to tighten monetary conditions by applying upward pressure directly onto gilt yields and, if effective, could lead to a lower required terminal rate to fight inflation.

Key takeaways

  • The Bank of England raised the base rate by 0.50% to 1.75%.
  • The vote was split eight-to-one in favor of a 0.50% hike, with the lone dissenter voting for a 0.25% increase.
  • As of 12:30 UKT, the 10-year GBP swap traded at 2.05%, the 5-year at 2.30%, and the 2-year at 2.65%.
  • The market is currently pricing in a 70% chance of 75 bps in hikes across the next two meetings, with a total of 1.00% in hikes expected across the three remaining MPC meetings in 2022.
  • The Bank of England retained the language to act "forcefully" against inflation but copies the Reserve Bank of Australia (RBA) stating policy is "not on a pre-set path".

Pressure on the BoE to act meaningfully in the fight against inflation was high coming into this MPC meeting after 0.75% and 0.50% base rate increases from the Federal Reserve and ECB, respectively, at their most recent meetings. The BoE now expects inflation to hit 13% by the end of the year and remain at “very elevated levels throughout 2023”, aided by increases in energy prices.

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The longevity of the rate hiking cycle will be challenged by the worst economic growth outlook since the Great Financial Crisis. The BoE now forecasts that the U.K. will fall into a recession in Q4 this year and remain as such until Q1 2024. The U.K. gilt curve inverted between the 2- and 10-year maturities, a prominent sign of oncoming recession, for the first time since 2019 immediately following the announcement. Despite the looming headwinds, the meeting minutes highlighted that U.K. labour market demand had “remained strong” with vacancies remaining close to their record high in the three months to June.

The BoE also shed more light on how the central bank’s quantitative tightening (QT) programme would work, the first of its kind in a major economy. Active gilt selling is likely to start in September – following a largely processional confirmation vote – and the MPC has set a target pace of GBP 10B per quarter. When added to the current tapering programme, that brings up a total APF reduction of GBP 80B over the next 12 months. The BoE will also launch a new Short-Term Repo facility, aiming to keep short-term market rates close to the set base rate throughout the balance sheet reduction process. They will manage this objective by allowing counterparties in the interbank market to borrow unlimited amounts of reserves for 7 days. This will ensure that banks can meet their minimum deposit threshold without needing to source reserves outside of the facility at higher rates. The BoE added that there would be a “high bar” to altering the plan as they look to unwind the asset mountain acquired throughout the COVID-19 pandemic. Alongside gilts, the APF will also sell their relatively small holding of high-grade corporate bonds. The QT mechanism represents a powerful new tool to fight inflation and will help the BoE fend off critics who believe that despite being the first major central bank to raise rates, the BoE has been far too timid and systematic in its continued 0.25% base rate hikes. It is notable that the BoE has just become the 71st central bank globally to raise rates by 0.50% or more in 2022.

Suella Braverman, the U.K. attorney general and ally of Tory leadership favorite Liz Truss, has suggested that Truss would examine the BoE’s “exclusionary independence on interest rates” should she become Prime Minister. Braverman retrospectively criticized the speed of reaction from the BoE when inflation began to emerge in Q3 2021 and added that Truss had made it clear to her that she “wants to review the mandate that the Bank of England has and see whether it’s fit for purpose”.

U.K. investors will now turn their focus to the UK GDP data to be released next Friday. Barring any emergency meetings, the next MPC meeting will be held on September 15, with the final meetings of 2022 to be held in November and December.

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