UK rates are on hold… but for how long?

The importance of this Thursday’s Monetary Policy Committee MPC meeting is growing, even if a rate hike is unlikely.

Markets are now pricing in a 30% probability of a rate hike by the end of 2019, as opposed to 0% in early April.

The resilience of the official data explains this move.

Employment data has been the UK economy’s main area of strength with unemployment cementing a 44-year low of 3.9% and total weekly wages growing at 3.5% (by three month, year-on-year comparison), the strongest growth rate since June 2008.

Furthermore, consumers appeared to have shrugged off Brexit uncertainty with strong retail sales growth.

Whilst the February GDP print of 0.3% (last three months verses previous 3 months or 3M/3M) was stockpiling inspired, the services sector (which contributes to around 79% of GDP) has remained strong, growing by 0.4% (3M/3M)in February after four consecutive rolling 3M/3M growth of 0.5%.

The power of numbers

All else equal, the strength in official data may provide merit to an interest rate hike.

This argument could be furthered by the recent rise in oil prices and the upcoming removal of the energy tariff cap, potentially resulting in inflation overshooting the 2% MPC target in coming months.

However, there are three caveats:

Firstly, the continued anguish of Brexit uncertainty and its “scarring” impact on businesses means Governor Carney would not want to place a further burden on investment, when it is already flat-lining.

Secondly, if the past is any indicator, the Bank of England (BOE) is likely to withstand inflationary pressures and keep rates on hold in the face of political headwinds.

After the Brexit referendum, Consumer Price Index (CPI) rates rose as high as 3% before an interest rate hike occurred, just under 18 months after the referendum itself.

Should CPI rise above the BOE’s target in the coming months, it’s unlikely to be as severe as this.

Signs of contraction?

Third, strong employment and GDP data are showing some cracks.

The Recruitment and Employment Confederation (REC) report on jobs showed companies delayed plans to hire staff in February and the indicator fell below 50 before recovering modestly to 50.3 in March.

This survey and other surveys measuring wage growth have also moderated recently.

Survey data has also suggested service sector output could stutter in March. The services Purchasing Managers Index (PMI) fell below 50 in March to 49.8, signalling contraction.

The stockpiling effect on GDP growth in February cannot be ignored and whilst it would mean a strong Q1 GDP reading is likely, firms will use up excess inventory in Q2 and this could mean a reversal in production output growth.

The trend of decreasing inflation is unlikely to change in the near term.  UK CPI held at 1.9% in March, below the BOE’s 2.0% target while RPI fell to its lowest level since November 2016 at 2.4%.

What are the implications for investors?

In light of these factors, it’s more likely that a hike won’t occur before 2021.

Whilst a modest overshoot in inflation could occur as a consequence of the BOE’s more asymmetric view of inflation at this point, we would argue that 10-year breakeven inflation in the UK remains expensive at 3.25%.

This leaves investors with a very unattractive -2% real yield for 10 year inflation linked bonds.

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