BOE Preview for November: Walking a Tightrope.

What to Expect:

1. Rate Cut: We expect the Bank of England (BoE) to match market expectations by announcing a 25 basis point rate cut at this week’s meeting, lowering the Bank Rate from 5.0% to 4.75%. This would mark the second reduction in the current easing cycle, following a similar cut in August.
2. Vote Split Prediction: The Monetary Policy Committee (MPC) is likely to deliver an 8-1 vote in favor of the cut, with Catherine Mann as the lone dissenter. Mann remains a consistent hawk, advocating to keep rates unchanged in response to ongoing inflationary pressures.
3. Cautious Approach: In light of recent fiscal developments, including the expansive Autumn Budget introduced by Chancellor Rachel Reeves, the BoE is expected to maintain a cautious tone. The budget’s significant stimulus measures raise concerns about inflation, prompting the MPC to tread carefully. Even as easing continues, policymakers are unlikely to adopt an overly dovish stance that could unsettle financial markets.
4. Gradual Easing Guidance: The BoE will probably emphasize a gradual approach to rate cuts, sticking to a quarterly easing schedule through 2025. Concerns over bond market stability, particularly following a sharp 20 basis point rise in Gilt yields in response to the Autumn Budget, will deter the MPC from signaling a more aggressive trajectory. This heightened market sensitivity underscores the need for a measured approach.
5. Inflation Concerns: Despite a decline in headline inflation, risks remain significant. Domestically generated inflation continues to be elevated, with core inflation at 3.2% and services inflation at 4.9%, well above the BoE’s 2% target. These persistent figures justify a cautious monetary policy stance as the committee monitors for a sustained decline in price pressures.

To Cut or Not to Cut: The Monetary Policy Dilemma.

The Bank of England faces a high-stakes dilemma as it contemplates its next move, with significant implications for bond markets.

• Risk of a Rate Cut: Lowering rates amidst an expansive fiscal policy could backfire by fueling inflationary pressures. If market expectations of rising inflation take hold, bond markets may react with heightened volatility, driving Gilt yields higher. This spike in yields would increase the cost of government borrowing, making public debt more expensive to service. Rather than easing financial conditions, the rate cut could paradoxically tighten them, posing challenges for both the government and the broader economy.
• Risk of Holding Rates Steady: On the other hand, opting to keep rates unchanged—or hinting at a slower pace of future cuts—could trigger market disappointment. Investors who have already priced in rate reductions might rapidly adjust, leading to a repricing of financial assets. This could ripple through the economy, pushing up borrowing costs for businesses and consumers, dampening investment, and curbing consumption, potentially stalling economic growth.

This delicate balance is why we expect the BoE to cut rates to soothe markets while maintaining a cautious approach.

Focus on the Monetary Policy Report (MPR).

This week’s Bank of England meeting will focus heavily on the Monetary Policy Report, which outlines the economic analysis and inflation forecasts that guide the BoE’s policy decisions. Significant revisions to these projections are expected from August, driven by the fiscal impact of the recent UK Autumn Budget.

The Autumn Budget introduces £100 billion in public investment, which is likely to stimulate both economic growth and inflation. Furthermore, it will result in a substantial increase in Gilt issuance, with £94.9 billion projected over the next four years. This surge in government borrowing has already unsettled bond markets, and the BoE will need to tread carefully to avoid further volatility.

Although a rate cut is almost fully priced in by markets, the way the BoE communicates its policy will be critical. If the central bank strikes a dovish tone while also projecting stronger growth and higher inflation, it could worsen bearish sentiment in Gilts. The 10-year Gilt yield has already climbed by 20 basis points, breaching 4.4% for the first time since last November. The Monetary Policy Committee will have to carefully balance its messaging to maintain market stability.

UK’s Economic Crossroads: Easing Inflation Meets Persistent Wage Pressures and Fiscal Stimulus.

The macroeconomic situation in the UK remains complex, with a mixed picture emerging from recent data. Headline CPI inflation has fallen to a three-year low of 1.7% in September, offering some relief. However, core inflation remains stubbornly high at 3.2%, and services inflation stands at 4.9%, both significantly above the Bank of England’s 2% target. This persistent inflation, especially within the services sector, complicates the monetary policy outlook.

Wage growth adds another layer of concern. Average weekly earnings are still elevated at 3.8%, rising to 4.9% when excluding bonuses. The anticipated deceleration in wage growth may not materialize, especially with upcoming increases in minimum wages. Higher wages could become more entrenched, leading to greater consumer spending. While this might boost economic activity, it also exacerbates inflationary pressures, complicating the BoE’s task.

Additionally, the effects of fiscal loosening present further challenges. Even if inflation gradually comes under control, the substantial stimulus from the Autumn Budget is expected to prolong inflationary pressures. This may necessitate a more extended period of higher interest rates, making it difficult for the BoE to adopt a more accommodative stance in the near term.

Gilt-Treasury Connection: How the US Election Could Shake Up UK Bond Markets

The relationship between UK Gilts and US Treasuries has become increasingly significant, especially as we approach the US presidential election on November 5. Historically, Gilt yields have shown a strong correlation with their US counterparts, and this week’s election could amplify that relationship. If volatility spikes in US markets, it is highly likely that UK Gilts will mirror movements seen in US Treasuries, given the interconnected nature of global fixed-income markets.

In the event of a red sweep, US Treasury yields are expected to resume their upward trajectory, potentially nearing 5% by year-end. This rise would likely spill over to UK Gilts, pushing 10-year Gilt yields higher. Such a scenario could lead to tighter financial conditions in both markets, despite central banks’ ongoing rate cuts. Investors should be mindful of the risk that rising yields in the US could exert upward pressure on UK borrowing costs, complicating the BoE’s efforts to manage inflation and stimulate growth.

Conversely, if Kamala Harris wins the presidency, markets may price in lower US Treasury yields, potentially dropping 10-year yields to around 3.6% amid a correction in stock markets and renewed risk aversion. This decline in US yields could cause UK Gilts to adjust lower as well, offering some relief to the UK bond market. However, given the profound challenges that UK politicians and policymakers are facing—ranging from fiscal pressures to persistent inflation—there is a possibility that UK Gilts could underperform relative to US Treasuries in the long term, especially under a blue sweep scenario.

Implications for Investors.

Investors should prepare for increased market volatility as the BoE’s rate decision and communication unfold. A dovish tone from the central bank may drive Gilt yields higher, impacting bond portfolios and raising borrowing costs. To limit exposure to interest rate risk and price fluctuations, investors might consider shifting to short-term Gilts, which tend to be more stable. Shorter-duration bonds are less sensitive to interest rate changes, making them a more resilient choice during periods of rising yields or uncertainty. Currently, the 2-year Gilt (GB00BL6C7720) offers a coupon of 4.125% with minimal duration risk. For a broader approach, the Lyxor UK Government Bond 0-5Y DR UCITS ETF (GIL5) provides exposure to UK government bonds maturing within five years, helping investors manage volatility while minimizing exposure to long-term interest rate movements.

Equity markets might see mixed reactions. On one hand, lower interest rates are generally supportive of equities, but persistent inflationary pressures and a cautious BoE stance may weigh on investor sentiment, particularly in sectors sensitive to rising costs. Property and real estate investments may also feel the impact, as a slower rate-cutting trajectory could maintain higher mortgage rates for longer, affecting housing demand.

For currency traders, the outlook for the British pound will depend heavily on the BoE’s ability to reassure markets. Any sign of hesitation or conflicting messaging could weaken the pound, especially if inflation concerns remain front and center.