Hot on the heels of Wednesday’s U.S. Federal Reserve meeting, the Bank of England delivered its own 75 bps rate hike today. But that’s where the similarities end. While the Fed messaged that investors’ expectations for further rate hikes had not gone far enough, the BOE messaged that investors’ expectations had gone too far.
Going forward, we expect the BOE to pivot from rate hikes to proactive balance sheet management. This should allow past rate hikes to filter through to the real economy, avoid the risk of overtightening, and improve market functioning.
Our Take on Today’s Meeting
As investors expected, the BOE raised interest rates by 75 bps, to 3.0%. Our take is that this outsized move reflects the need to not only tame inflation, but to also restore credibility after the UK’s “mini-budget” (see the following box on ‘“Lessons from the UK”).
Alongside today’s hike, the UK’s Chancellor of the Exchequer reaffirmed the bank’s independence in achieving its 2% inflation target. And just a few days ago, the BOE launched the active sale of government bonds from its balance sheet. Its Monetary Policy Committee (MPC) decided to start selling bonds at its September meeting, but delayed those plans after the financial market turbulence that followed the mini-budget.
Today’s seemingly hawkish 75 bps hike came hot on the heels of the same decision by the Fed. Now that credibility in the UK’s fiscal approach has partially recovered, and in contrast to the Fed’s tone, the BOE signalled that it will tread cautiously with regards to further rate hikes. It also clearly messaged that it considered investors’ expectations for further rate rises to be too high.
Our view is that the BOE’s more dovish messaging on future interest rates comes hand-in-hand with more proactive balance sheet management. That would suggest financial conditions will continue to tighten even as the central bank eases off its aggressive rate hikes. Such a shift should improve market functioning (see “Market Technicals” below) and allow past rate hikes to filter through to the real economy. That, in turn, would enable the bank to better calibrate and endpoint that is appropriate to bring inflation back to target.
Although the Fed and the BOE appear to be on a similar journey when it comes to aggressive rate hikes, this week's signals that they are heading to different destinations.
Market Reaction
Investors’ reactions so far are consistent with a “dovish” hike. This becomes clearer when we contrast BOE Governor Andrew Bailey’s remarks with those of Fed Chair Jay Powell.
Governor Bailey emphasised that the BOE can afford to be more cautious in its tightening path. He backed this up by outlining the downside risks to growth from the war in Ukraine and the associated shock to import prices. By contrast, Chair Powell was clear about the need to err on the side of overtightening, to make sure that inflation is brought under control.
The reaction in bond markets reflects this divergence. The yield curve of gilts (UK government bonds) steepened after the meeting, led by higher yields at long end. The U.S. Treasury yield curve, by contrast, further inverted after Wednesday’s Fed meeting, hitting a new cyclical low (Figure 1).
The GBP/USD exchange rate is another way of illustrating the difference in tone between the two banks. The pound’s value fell 1.5% on the day of the BOE’s announcement, in U.S.-dollar terms, having rallied close to 9% since the mini-budget rout.
Beyond this cross-country comparison, the reaction in UK risk assets was muted at the time of writing.
Figure 1
The UK gilt yield curve (10-year yields minus 2-year yields) steepened after the BOE meeting, while the U.S. Treasury yield curve flattened after Wednesday’s Fed meeting.
PGIM Fixed Income and Bloomberg.
Lessons from the UK’s mini-budget
- Fiscal responsibility is crucial to ensure market confidence
The UK government’s September mini-budget tabled a large unfunded fiscal expansion. This made investors nervous, elevated the risk premium on government bonds, and weakened the currency. A weaker currency, in turn, raised the prospect of even higher inflation. Together with the government-led demand expansion, higher inflation would have resulted in even more aggressive BOE tightening.
The resulting tighter financial conditions, as well as the higher financing costs for corporates and households (for example via higher mortgage rates), are much like the vicious circle that has plagued emerging markets in the past. Restoring fiscal responsibility to break such a vicious circle requires a credible plan.
- The combination of tight monetary and loose fiscal policies means higher bond yields
Even if expansionary fiscal policy was designed to support growth in a responsible way, the combination of tight monetary policy and loose fiscal policy put upside pressure on interest rates. This combination can exacerbate bond market volatility, especially when yields rise after 10+ years at ultra-low levels in illiquid markets. The UK 10-year gilt yields had already risen 225 bps in 2022 before September’s mini-budget. News of further fiscal stimulus tipped the balance and accelerated the selloff. The attempt to expand fiscal policy by the previous UK government may seem like an isolated event. But this is a real risk in other economies, notably in Europe, where the authorities face a lot of pressure to use fiscal stimulus to lessen the blow of the energy shock and the cost-of-living crisis.
- Bond market selloffs expose financial pressure points
Financial markets and economic agents have been operating in abundant liquidity and ultra-low interest rates following many years of low inflation and ultra-easy monetary policies, including quantitative easing (QE). That environment is changing, as high inflation requires central banks to tighten policy rapidly.
The UK is no exception. The speed and extent of monetary tightening in the U.S., the Eurozone, and the UK is at its most aggressive in four decades. As a result, it is easy to see pressure points flaring up, e.g., highly leveraged UK pension schemes that were required to sell gilts to meet margin calls. Investors and policymakers are now alert to other potential areas of fragility that could lead to distress.
- Financial stability is harder to maintain when monetary policy tightens
Episodes of market stress in the last few decades have usually been resolved by loosening monetary policy. This included policy rate cuts, QE, and other ways of providing liquidity. But even when central banks tighten monetary policy using rate hikes or QT, liquidity can still be provided. But such actions are more challenging because they have to be surgical against a backdrop of tighter, not looser, financial conditions.
The rout in financial markets after the UK’s mini-budget meant that the BOE had to buy gilts days before it was supposed to start selling them in its QT programme. That contradiction did not restore market confidence, especially when bond markets were as illiquid as described in Figure 2.
Market Technicals
From a technical perspective, finding a marginal buyer of developed-market treasuries in the absence of central bank purchases is proving difficult. The UK is a case in point as its government works through its budget without the power of QE. The dramatic conclusion to the last decade plus of asset purchases and money printing is becoming increasingly evident via the UK’s mini-budget situation and the U.S. Treasury’s consideration of Treasury market buybacks.
Recent events in the UK have grabbed the attention of policymakers around the world. The US Treasury Department, for example, now questions whether it should get involved in the Treasury market via buybacks (buying existing debt on the secondary market). Its intention here would be to improve market functioning by correcting extreme dislocations at specific points of the curve.
The BOE is doing its part to address some of the market issues. Selling gilts into the market, so-called quantitative tightening (QT), will alleviate market-technical issues at the front end of the gilt yield curve, where the BOE owns most of the floating-rate debt outstanding.
UK pension schemes’ problems after the mini-budget are not isolated but serve as a working example of what it looks like to shift from a QE world to a non-QE world. Figure 2 is a measure of government bond market dislocations in the UK, the U.S., and Germany and how they have grown as central banks embark on their unprecedented hiking cycles.
PGIM Fixed Income and Bloomberg.
In our analysis, dislocations in the gilt market will improve as the BOE continues its monetary tightening by relying more on active sales and less on rate hikes.
Conclusion
The BOE’s Monetary Policy Report and accompanying press conference emphasised downside risks to UK growth and upside risks to inflation—an assessment that was supported by a dovish tone from Governor Bailey and other MPC members.
Their approach contrasts with the hawkish tone of Fed Chair Powell during his press conference on Wednesday. Investors expected both the BOE and the Fed’s policy adjustments. However, the steeper UK yield curve versus the U.S. and the weaker pound sterling relative to the U.S. dollar are consistent with the divergent tones in their respective press conferences.
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