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● Crisis averted: The UK narrowly avoided a nasty financial shock last week. The massive sell-off in the gilt market after the government bungled its fiscal plan left the UK pension market long on risk but short on liquidity. The market would have collapsed had the Bank of England (BoE) not intervened by promising to put a de-facto price floor under gilts at maturities of 20 years and above. The BoE’s decisive action ended the panic. While yields across all maturities are well above the pre-budget level, the panic selling is over, and yields have fallen back from their highs – Chart 1.
● Spot the difference: Due to lack of credibility, the UK government caused a panic with a fiscal plan to add a significant (but not huge) 1.5ppt to the structural deficit. However, because of its mostly solid credibility, the BoE ended the panic with room to spare. Whereas the BoE initially promised to intervene on “whatever scale is necessary” with a pledge to buy £5bn per day of longer dated gilts, in the end it has not even come close to this. After seven days of purchases (as of yesterday), the BoE has had to buy just £3.8bn out of £35bn planned so far – Chart 2.
● Balance sheet confusion: Rescuing the government from its self-inflicted crisis complicates the policy outlook for the BoE. After the financial policy division was forced to backstop the gilt market, investors are confused about what the BoE’s monetary policy arm will do about its planned bond sales – so-called quantitative tightening (QT). As long as the gilt market remains orderly after the emergency intervention ends on 14 October, there is no reason why the BoE’s QT plans should not resume. However, the market disorder increases the risk of another bond market tantrum.
● The damage is done: Even though the panic seems to have ended, the tightening of financial conditions that occurred last week has only partly reversed. Gilt yields remain elevated and, crucially, UK commercial banks have dramatically increased the interest rates they offer on mortgages. Some five-year rates are as high as 6% – more than three times their January 2022 level. This dramatic rise in the cost of mortgages will depress demand and deepen the downturn. In the end, it probably now means that BoE needs to do less to control inflation. But that may not be an option.
● Is the BoE now cornered into making a policy error? Probably. Behind the scenes, policymakers may be concluding that the worse-than-expected recession due to the sharp deterioration in the mortgage market will largely dis-inflate underlying domestic price pressures by enough to return inflation to the 2% target once the big energy-related surge fades early next year. However, the market is looking for a huge 125bp hike at the November meeting followed by another big 100bp in December – with a peak bank rate of 5.7% by June next year. At some 350bp above the current 2.25% bank rate, market pricing far exceeds what will be required to tame UK inflation. However, after last week’s debacle, the BoE cannot risk its own credibility by falling too far behind market expectations, at least in the near term.
● BoE pivot could come earlier than the markets expect: To shore up confidence and prevent further disorder in bond markets when it begins active QT, we expect the BoE to largely meet market expectations in the near term by hiking 100bp in November and a further 75bp in December. But by the turn of the year, it should be obvious to markets that the UK is in the grip of a disinflationary recession and that less tightening is required via bank rate rises to control inflation. Presently, the market expects the BoE to keep rates on hold through H2 2023. In our view, it looks much more likely that the BoE will be cutting rates by then in order to prevent inflation falling too far below the 2% target in 2024.
Berenberg
Senior Economist
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