Bank of England preview: Rate cuts in mind, but patience required. Bank of England preview: Rate cuts in mind, but patience required. Bank of England preview: Rate cuts in mind, but patience required.

Bank of England preview: Rate cuts in mind, but patience required.

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:

  • Markets are expecting a dovish hold by the MPC, but a June rate cut is not yet priced in by markets. 
  • A 7-2 vote split is in the cards. Although the BOE shifted away from a hawkish stance at the previous MPC meeting, it remains to be seen whether its dovish bias strengthens, potentially setting the stage for a rate cut in June.
  • Such an outcome could bring downside in sterling, watch GBPAUD and EURGBP.
  • Should the outcome disappoint, we could see a reversal of this week's gains in Gilts, with sterling likely to strengthen marginally.
  • Focus will also be on the MPC's inflation projections. A revision of the 2026 inflation forecast back to 2% would indicate that the BOE might consider an aggressive rate-cutting strategy going forward.

Financial markets are bracing for UK inflation to reach 2% in the second quarter, following comments from Governor Andrew Bailey indicating a significant anticipated decline in April's inflation figures. Bailey attributed this expected drop to the UK's distinctive approach to household energy pricing. Yet, wages and services inflation remain at 6%.

While the Bank of England (BOE) is exploring opportunities to begin reducing interest rates, this week’s MPC meeting will likely show that the rate cut cycle ahead remains uncertain. The data Bailey referenced will not be released until May 22nd, making it risky to pledge to an aggressive rate cut cycle ahead. Therefore, even if the Bank of England pre-commits to a rate cut this summer, it is unlikely to announce further cuts soon, especially given the uncertain monetary policy trajectories of the European Central Bank and the Federal Reserve. This leaves UK monetary policy decisions heavily reliant on upcoming economic data.

Vote split: on hold with a dovish bias.

At the last Monetary Policy Committee (MPC) meeting, the Bank of England (BOE) members decided by an 8-1 majority to maintain interest rates unchanged. Haskel and Mann shifted their positions from favoring a rate increase to supporting a hold, while Dhingra voted for a cut. As inflation continues to decline, a more dovish stance may emerge. In this meeting, it wouldn’t be surprising if the vote split adjusts to 7-2, with Ramsden potentially aligning with Dhingra to advocate for a rate cut. Notably, although Ramsden is recognized as a hawk, he has recently expressed the belief that inflation risks are more balanced and that inflation could stay around 2% for three years.

Currently, financial markets expect the BOE to cut rates by 56 basis points by year's end, a decrease from the 172 basis points forecasted at the start of January. While the likelihood of two rate cuts now appears greater than that of seven, market sentiment might shift towards expecting further cuts if policymakers continue to express confidence in economic data, hence the potential for cutting rates.

MPC projections.

In February, the Monetary Policy Committee (MPC) projected that inflation would decrease to 2.3% by 2026, a revision from the November forecast, which anticipated inflation to drop to 1.9% within the same period. Given the recent rise in Gilt yields, which reflects market adjustments pricing out rate cuts for this year, there is now a likelihood that the MPC’s CPI forecasts for 2026 might be revised downward to 2%. This adjustment would invite markets to price more rate cuts for this year.

Challenges to early and aggressive BOE rate cuts:

  • Core and service inflation remains elevated 4.2% and 6% respectively.
  • Wages are still growing 6% YoY.
  • UK growth is poised to rebound in the second half of the year.

Market implications.

Uncertainty surrounding monetary policies and the trajectory of inflation is expected to maintain bond and FX markets on edge. This suggests that although the response to Thursday's Bank of England (BOE) meeting may be pronounced, Gilt yields are likely to remain rangebound over the medium term.

There are two probable outcomes from this week's Bank of England (BOE) meeting:


1. Hold scenario, no changes to forward guidance, no changes in vote split. That will allow the MPC to keep the options open for the timing of the first-rate cuts. That might put in doubt a June rate cut, resulting in a bear flattening of the Gilt yield curve.

2. Hold scenario, changes to forward guidance and/or changes in vote split.  The dovish bias will prompt to a bond rally leading to a steepening of the yield curve.

FX implications (contributed by Charu Chanana)

There is potential for downside for GBP given:

  1. Market pricing for BOE would likely need to shift dovish if the BOE vote split shifts dovish. However, risk for a hawkish repricing may remain limited even if there is no change in BOE tone given that a June rate cut is only priced in with 45% probability. Risk/reward is asymmetric.

  1. Dollar could sustain its resilience into the US CPI release on May 15 as Fed commentaries likely stay balanced until fears of reflation subside.

  1. GBP has also shown a high correlation to equity sentiment. If US equities lose momentum on fears of high-for-longer interest rates or earnings pull dissipating, that can impact high-beta sterling negatively.

As such, GBPUSD could test 61.8% fibo retracement level at 1.2428 or even head towards April lows of 1.23 in the medium-term. It may also be interesting to play the risk of dovish repricing in BOE on GBP crosses, particularly with short GBPAUD given stickier inflation in Australia and expectations that the Reserve Bank of Australia could well be the last of the G10 central banks to cut rates. EURGBP could also have some room to run higher, given an ECB June rate cut is fairly priced in, but watch for the resistance at 0.8650.

Source: Bloomberg

Gilts: what to expect.

Should the Monetary Policy Committee (MPC) adopt a dovish stance, ten-year Gilt yields are poised to continue their decline toward 3.94%-3.91%. However, this level is likely to be rejected as the trajectory of inflation remains unclear, with both wage and service inflation still elevated.

Conversely, if the Bank of England (BOE) takes a more cautious approach, yields are expected to start climbing back toward 4.36%.

Risk-reward proposition for 10-year gilts. For investors considering ten-year Gilts (GB00BPJJKN53), which currently offer a yield of 4.15%, the risk and reward scenario over a one-year holding period is as follows: if yields rise to 5.15%, the position will likely incur a loss of 2.57%. However, if yields fall to 3.15%, potential gains could reach 11.26%.

Source: Bloomberg.

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