Bank of England signals an interest rate rise – weekly update 18 September

Is a UK interest rate rise on the horizon?

In what was a busy week for the UK, the Bank of England’s Monetary Policy Committee (MPC) gave its strongest signal yet that interest rate hikes were on the way as inflation surged. In its official release the MPC suggested that, based on the current outlook, “some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target.” The announcement sent sterling to the highest level since the EU referendum as UK government bonds sold off sharply.

Markets were clearly taken by surprise with the sudden hawkishness, though as we highlighted last month the committee had already flagged concerns over market complacency, so this could be seen as a ‘take the hint’ message. The market move was further reinforced on Friday when one of the most dovish MPC members, Gertjan Vlieghe, appeared to change tack during a speech to economists. He told the audience that “we are approaching the moment when the bank rate may need to rise”. Market implied expectations for an interest rate hike by the end of the year rose from 23% before the meeting, to 66% by the end of the week.

The MPC statement came after UK CPI inflation surged by 0.3% to 2.9% year on year (yoy) ahead of forecasts for 2.8%, whilst core CPI was also up 0.3% to 2.7% (2.5% was forecast). There will almost certainly have been some seasonal and technical factors contributing to the volatility recently, but clothing and footwear were significant contributors to inflation as ‘Brexit’ currency effects begin to come through in the import-sensitive sectors.

Employment data showed the unemployment rate falling 0.1% to 4.3% for the three months to July, however there was disappointment in the growth of average weekly earnings which remained at 2.1% yoy, below the 2.3% expected. On the subject of wages, it is also worth highlighting signs that the Government is relaxing restrictions that capped pay increases to 1%, with the announcement that both prison and police officers will see pay rises above this cap as part of the current review cycle.

It remains to be seen whether this will ultimately end up as fiscal stimulus through the back door (the current proposal is that these pay increases will be funded within current budget constraints) but this clearly helps improve the aggregate wage growth outlook.

US numbers falls short of expectations

There were disappointing economic numbers out of the US, with Retail Sales much worse than expected, falling -0.2% month on month (mom) in August versus the 0.1% growth expected. The poor reading was not just driven by automobile sales either, with the ex-Auto and Gas figure increasing just 0.2% versus 0.5% expected.

Adding to the gloom, the report also came with substantial downward revisions to the June and July readings. July retail sales were revised down from 0.6% to 0.2% whilst the June figures were revised from 0.3% growth to a -0.1% fall.

Industrial production was also dismal, falling -0.9% mom from 0.2% in July and significantly worse than the 0.1% expected, whilst capacity utilisation fell from 76.7% to 76.1% (no change was expected). The Federal Open Market Committee (FOMC) meeting this week could face a challenge reconciling these soft data with last week’s CPI inflation print finally beating expectations, coming in at 1.9% yoy (from 1.7% previously and expectation for 1.8%).

Last week’s other events

• US core CPI inflation beat expectations. Stripping out food and energy, inflation was unchanged at 1.7%, versus 1.6% expected. Real average weekly earnings growth slowed from 1.1% yoy in July to 0.9% in August.
• China’s data releases also came in below expectations across the board. Retail Sales slowed from 10.4% to 10.1% yoy (10.5% was expected), Industrial Production growth slowed to 6.0% yoy (from 6.4%, an acceleration to 6.6% was expected), and Fixed Asset Investment growth fell from 8.3% to 7.8% (8.2% expected). Foreign Direct Investment was more positive, up from 2.3% to 9.1% yoy.
• Eurozone Industrial Production for July accelerated from 2.6% to 3.2% yoy, though 3.3% was forecast.

The markets

Sterling assets were the key movers on the week, as sterling rallied sharply, pushing gilt yields up and UK equities down.

One month performance of major asset classes

Equities

UK equities fell sharply on Thursday and Friday, with the MSCI United Kingdom down -2.1% for the week, whilst most other major equity regions were in positive territory. In Japan, the TOPIX index returned 2.9%, whilst the US’s S&P 500 advanced 1.6% and Europe (excluding the UK) returned 1.5%, as measured by the MSCI Europe ex-UK index. Emerging markets also made a reasonable gain, with the MSCI Emerging Markets Index rising 1.5%.

Bonds

UK government bond yields were significantly higher (meaning prices were lower) last week. Having ended the previous week just below 1%, yields increased 31 basis points (bps) to close at 1.31%. German 10-year bund yields were 12 bps higher to end the week at 0.43% whilst the equivalent US Treasury yields were 15 bps higher to close at 2.20% on Friday.

Commodities

Oil continued to grind higher through the week, with Brent Crude ending at US$55.62 per barrel. Gold surrendered some of its recent strength to finish at US$1,320.18 per ounce, whilst copper was also weaker, closing on Friday at US$2.93 per lb.

Currencies

Sterling rallied following the Bank of England meeting, advancing between 3.0% and 5.9% against the major developed currencies. Sterling closed on Friday at US$1.36, €1.14 and ¥151.

The week ahead

Wednesday’s FOMC meeting will be closely watched, with the committee expected to announce the start of the balance sheet unwinding process, dubbed ‘Quantitative Tightening’ (QT), whilst the Bank of Japan’s monetary policy meeting concludes overnight into Thursday. Wednesday also sees UK Retail Sales figures released, where markets expect 1.1% yoy from 1.3% previously, whilst on Friday Markit PMI readings for the Eurozone and the US are due out. The daily breakdown is as following:

Monday – UK house prices are released just after midnight, in what is otherwise a very quiet day.

Tuesday – Eurozone Construction Output and the ZEW surveys of business sentiment are out in the morning, and then in the afternoon US import and export prices are reported, alongside Housing Starts and Building Permits.

Wednesday – Japan starts the day’s data releases in the early hours of the morning, with trade data being reported. We then have UK retail sales later in the morning, as covered above. In the US, existing home sales and mortgage applications data are reported in the afternoon, and the Fed’s monetary policy decision is due out at 7pm UK time, along with updated economic forecasts and a press conference.

Thursday – the latest output from the Bank of Japan’s monetary policy committee is due out, with no formal change expected, though as usual the language will be carefully examined for any shift in signalling. Industrial activity and retail sales data are also due out from Japan around UK breakfast time. In the afternoon, Eurozone Consumer Confidence data are released, and in the US we have jobless claims data and the Conference Board’s Leading Index to look forward to.

Friday – the day starts with Eurozone PMI data from Markit. Services PMI is expected to increase marginally from 54.7 to 54.8, whilst Manufacturing PMI is expected to be slightly lower, slipping from 57.4 to 57.2. Later in the morning, UK Order Trends from the Confederation of British Industry is reported. In the afternoon, US PMI is reported from Markit, with Services PMI forecast to have slipped 0.2 points to 55.8 whilst Manufacturing is expected to be up 0.2 points to 53.0.