Following on from last week’s decisions for US and eurozone interest rates, today was the turn of the Bank of England (BoE). At the meeting, the committee voted 7-2 to raise rates by 0.5% to 5.0%, with two dissenters voting to keep rates unchanged.
For many market participants 0.25% was expected, and fully priced by the market. But the real question ahead of the meeting was whether the committee would step up the pace and hike by the 0.50%. The market was only pricing a 40% chance of a 50bps hike which highlights the lack of credibility that surrounds the Monetary Policy Committee. The data since May has been unequivocally strong in all the wrong areas for the BoE: first, Consumer Price Index inflation exceeded even the most lofty expectations and remains stubbornly high, particularly core inflation which rose to 7.1%; and second, April’s labour market data showed the unemployment rate falling to 3.8%, and wages rising to 7.2%.
On this basis, a 50bps rise was both justifiable and required if the committee wanted to regain any semblance of credibility. The immediate market reaction has seen gilt yields fall, this perverse reaction highlights that the 50bps increase is a signal to the bond markets that the BoE is serious and committed to tackling the inflation problem that is crippling the UK economy, and the initial reaction at least was that the market seems to believe them.
The BoE has moved rates substantially since December 2021; and there is plenty of sympathy with the BoE’s view that there is a considerable amount of tightening yet to be felt by the economy. Historically, monetary policy has taken effect with a lag of 12 to 18 months, but in this cycle, that effect is taking even longer to come through due to the very high percentage of fixed rate mortgages. Markets are anticipating that inflation will end the year at 5% and interest rates will reach 6.0%, this moves real interest rates into positive territory. At which point we believe that the BoE should, at the very least pause like the US Federal Reserve and take stock.
Yields on short-dated UK government bonds have moved a long way since April. A portfolio of short maturity UK gilts currently yields in excess of 5%, which in my view should look a very attractive proposition to investors, particularly if the bank pauses or stops its hiking later this year. Our view remains that the current level of gilts look attractive based on historic valuations and economic fundamentals, and for the first time in many years, it is appropriate to be long duration versus gilt indices and overweight the UK relative to global markets.
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