Head of Fixed Income Strategy
Summary: With inflation falling faster than the November BOE’s monetary policy report forecasted, a shift in inflation projections is likely to show UK CPI dropping to the 2% target a year earlier than expected. Therefore, conditioning assumptions could reveal a deeper and faster rate cut cycle in the next three-year period, leading markets to double down on interest rate cut expectations for this year. Dispersion in MPC votes will also be a focus. Even one single member voting to cut rates could signal that rate cuts are back on the table. We expect Bailey to try to maintain a cautious approach highlighting lagging core inflation and wage growth. Nonetheless, disinflationary trends coupled with a less aggressive BOE will lead the UK yield curve to bull-steepen, calling for duration extension.
A new set of economic forecasts will be the focus at this week’s BOE monetary policy meeting which are likely to revise inflation downward among other metrics.
According to the November MPR, by the end of 2023 inflation was expected to be at 4.6%, unemployment at 4.3%, and wages at 7.25%. Inflation dropped to 4% in December, unemployment ended the year at 4.2%, and wages dropped to 6.5% already in November.
The November projections showed inflation to revert close to the 2% target by Q4 2025. That is assuming a bank rate of 5.1% at the end of this year, dropping to 4.2% only in 2026. Faster disinflationary trends could lead the MPR to expect CPI falling close to target already at the end of this year and below 2% by the end of 2025. Such revisions will have enormous implications for the expected interest rate cutting cycle ahead, as the BOE will need to cut faster and deeper to take the bank rate to a less restrictive level. The conditioning assumptions could therefore show the bank rate to fall conservatively to 4.5% this year, 4.2% in 2025 and below 4% in 2026. If that were the case, markets are going to double down on rate cut bets.
Currently, markets are pricing 110bps rate cut by the end of the year, starting in May. Dovish economic projections are likely to accelerate such expectations. As a consequence, the UK yield curve is likely to bull-steepen and disinvert further.
At the December BOE monetary policy meeting, three members of the MPC voted for increasing interest rates by another 25bps, while the remaining six voted to maintain the Bank Rate at 5.25%. Given the disinflationary evidence brought by the MPR, it is possible that at this week’s meeting we see the MPC unanimously voting to keep rates unchanged for the first time since September 2021, ditching the tightening bias the central bank held until now. In case one of the members votes to cut rates, that would be an early sign that interest rate cuts are back on the table, igniting speculation of a March cut. Whether such cuts will be delivered or not, is irrelevant, that would be enough to ignite a imminent bond rally.
With disinflationary trends accelerating across the globe, and central banks becoming less aggressive, the bull-steepening of yield curves will find fertile grounds, giving investors reason to extend their portfolio’s duration. Ten-year Gilts might fall to test support at 3.75%, which if they break, might see them dropping to Decembers lows of 3.43%.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
