Almost one year ago to the day the chief economist at the Bank of England, Andrew Haldane, gave a speech about the persistent weakness in underlying inflation and the implications for monetary policy. At the time, many investors (including me) and the consensus of the Monetary Policy Committee thought that the next move would be up given strong domestic growth, a tightening labour market and the transitory nature of much of the fall in headline inflation. Headline inflation was at 0.3%, which funnily enough is exactly where it is today. Given the somewhat prescient nature of these comments, what is the likelihood that the next move in official rates could be down, and what are the investment implications?
We can review investor expectation for the change in the Bank Rate by looking at the difference between where investors expect the Bank Rate to be in one year’s time, relative to today’s prevailing rate.
After spending 2015 expecting the next move to be up, investor sentiment has now shifted to reflect a good chance that the next move will be down. Our base case is for no move this year, with greater risk of a cut than a hike, and for a hike in 2017.
Whilst the Chancellor’s recent budget raised the deficit forecasts for 2016 and 2017, there is still a tightening in fiscal policy over the next two years. Meanwhile headline inflation is likely to remain below 1% until at least the fourth quarter, in turn eliciting further exchanges of letters between the Chancellor and the Governor of the Bank of England as to why inflation is so low. These factors combined with the uncertainty about both the upcoming Brexit referendum and the prospects for several emerging market economies, notably China, suggest that in the short term the risk of a cut outweighs the risk of a hike.
This means that despite the low absolute level of UK bond yields, short and intermediate UK rates are likely to be supported over the months ahead and indeed offer good value relative to other equally low yielding developed markets.