Investors At Odds With UK Policymakers On The Direction Of Interest Rates

Although the UK economy continues to face significant economic headwinds associated with Brexit, recent rhetoric from certain members of the Bank of England's Monetary Policy Committee suggests they are considering voting to raise the UK base interest rate in the coming months.

This would primarily be to keep inflation under control, with the economy near full employment and wage growth already edging higher.

MPC member hints at more imminent rate rise - reports

Nevertheless, market pricing suggests investors see little-to-no chance of a rate rise over the next 12 months.

On the contrary, it suggests a 20% chance the Bank of England will instead implement an interest rate cut by this time next year.

This is largely because certain recent economic data has come in weaker than expected; it now appears Brexit uncertainty is set to weigh more heavily on the economy, having been offset by emergency stockpiling earlier in the year.

At some point, the gap in expectations between the Bank of England and market will need to be addressed.

Will rates be raised?

We do not expect the UK policymakers to raise rates in the coming months, primarily as we expect the economy to deteriorate, with adverse implications for the labour market and wage growth.

Such a situation would also put downward pressure on sterling, but the scope for significant further sterling weakness is now more limited.

This is because the currency is already cheap in terms of many longer-term valuation metrics, following the losses it has sustained in recent years, and the fact that many foreign ends of sterling exchange rates are facing their own headwinds, particularly the euro.

As such, any imported inflation impulse is likely to be less powerful than the one that followed 2016's referendum, with commensurately less significant implications for monetary policy.

ECB to keep interest rates at 0% until mid-2020

Another caveat to UK policymakers' relatively hawkish stance is their outlook is contingent on a non-disruptive Brexit. Despite this, we think recent developments have made it even less likely that any deal will be reached in the short term.

Conversely, it appears that the risk of no-deal has risen in recent months, with a deal capable of garnering Parliamentary approval appearing out of reach and a high probability that a eurosceptic MP will be the next leader of the Conservative party.

Nevertheless, given Parliament's limited appetite for a no-deal secession, a general election may be needed to overcome the gridlock; in any case, we think it unlikely the Bank of England would raise rates under such circumstances.

Market implications

If the Bank of England decides to step back from rate rises, investors would likely begin to price in more aggressive rate cut forecasts.

Sterling would underperform, boosting UK equities, although domestically-focused UK small- and mid-cap stocks would likely underperform large, UK-based multinationals. Gilts would likely make gains due to falling yield expectations.

If we are wrong and the Bank of England signals an intent to raise rates, the opposite would likely play out. We would expect sterling to jump, with UK domestics outperforming UK-based multinationals. UK gilts would likely underperform within fixed income.

Edward Park is deputy CIO at Brooks Macdonald