Hiking cycle postponed, not cancelled
As expected, the Bank of England decided not to hike the Bank Rate at this meeting (vote count unchanged 7-2, a bit dovish as some had thought it might be 6-3), as economic indicators surprised to the downside. The seven members voting for staying on hold thought that it would be good to see ‘how the data unfold over the coming months to discern whether the softness in Q1 might persist’, as the ‘cost of waiting was likely modest’, supporting our view that the hiking cycle is postponed, not cancel led, but that there will be fewer rate hikes than previously thought. BoE governor Mark Carney highlighted a couple of hawkish things at the press conference: (1) he said that growth only needs to pick up slightly to be above potential (0.25% q/q), which should tighten the labour market further, and (2) domestic cost pressure is increasing with stronger wage growth. It is interesting that the projections (inflation staying above or at 2% over the forecast horizon and the unemployment rate to drop further to 4%) are based on the market pricing from before the meeting of approximately one hike a year the next three years. We stick to our call with one hike in H2 18 and one in 2019 with the next hike likely in August. That said, the probability of August has declined slightly, as we only get three months more data in August, which may not be enough for the majority of the BoE members.
Market expectations of future rate hikes dropped slightly after the announcement and UK interest rates dropped some 3-5bp across the 2-10Y yield with a modest steepening of the yield curve, as the shorter-dated tenors declined the most. The market is now pricing around 50% probability of a rate hike in August, while the first full 25bp rate hike is priced to arrive in February 2019. Timing of the next BoE rate hike remains highly data dependent and we see market pricing as fair for now, with risks skewed to the upside for UK yields in the coming months, if we are right in our call that the BoE will hike the Bank Rate in August.
FX outlook: we still look for a lower EUR/GBP in the medium and longer term
EUR/GBP traded higher on the announcement and was shortly above the 0.88 level. Especially the 7-2 vote in favour of keeping the Bank Rate unchanged might have been a disappointment for some GBP long players who had expected a more divided MPC (i.e. a 6-3 vote). With an August rate hike still in sight in our view, we see relative interest rates as neutral for EUR/GBP for now, but expect the GBP to eventually gain support from the rate channel. We target 0.88 in 1M and 0.8650 in 3M.
Longer term, Brexit remains a key driver for the GBP and while uncertainty remains high, we still expect EUR/GBP to eventually trade lower driven by Brexit clarifications and fundamental valuations. The turn in capital flows and FDI flows back into the UK, as indicated in the latest balance of payment data, suggest that a key headwind to the GBP seen in Brexit is reversing, supporting the case for additional GBP appreciation in the medium term. We target EUR/GBP at 0.84 in 6M and 0.83 in 12M (0.84).
Macro charts
Bank of England’s projections
