The Bank of England’s “Super Thursday” is behind us, and BOE Governor Mark Carney and colleagues will likely be happy with the outcome. While the amount of information released was substantial, the amount of news was much less so. The market opportunities that existed before the releases remain.
As expected, the recent falls in energy prices have reduced the near-term forecast for CPI (consumer prices index, a standard measure of inflation), with Carney stating that it remains quite possible we could see further negative CPI numbers in the months ahead. However, at the policy-relevant horizon of two years out, the BOE remains of the view that strong domestic demand and diminishing downward pressure from lower import prices will bring inflation up to 2%. Thereafter, CPI is expected to rise gently above the 2% target (see chart). These forecasts are based on the BOE Bank Rate following the path implied by markets, which currently suggests an initial 25 basis point (bp) hike in February 2016 and a cumulative 125 bp hiking cycle by the end of 2017.
While Governor Carney reiterated his view that the decision on whether to tighten policy will come into sharper focus around the turn of the year, the market assumption of a February 2016 hike seems to us the very earliest policy could be tightened. By the BOE’s own admission, CPI will still likely be below 1% in February, a level that would require the governor to write a letter explaining why inflation has undershot. To decide to raise interest rates while writing that letter would seem a little incongruous.
Notwithstanding our expectation of a later start to the hiking cycle, the cumulative 125 bps priced in for this cycle looks low based on history and our outlook for the economy. The average hiking cycle since MPC (the BOE’s Monetary Policy Committee) independence in 1997 is 130 bps, and the smallest cycle was 100 bps. This means the term premium embedded in the U.K. gilt market is negligible – and that, in turn, suggests U.K. investors should continue to look elsewhere for better value in their bond market exposure.