At next week’s MPC meeting, the Bank will want to soothe bond markets by highlighting downside risks. Rising bond yields pose a clear and present threat to the monetary policy path plotted by the Bank of England.
Markets have now discounted the possibility of negative interest rates. At the beginning of February, markets were pricing in a 40% chance of an interest rate cut this year. They are now pricing in a 30% chance of an interest rate hike by September of next year.
Laith Khalaf, financial analyst at AJ Bell, comments: “In a matter of weeks, markets have gone from worrying about negative interest rates, to pondering when monetary policy might tighten. The OECD expects President Biden’s $1.9 trillion stimulus package to add 0.5% to UK GDP in its first full year, and combined with the UK Chancellor’s renewed fiscal support, that sets the economy on a fairer course than expected at the beginning of the year.
“Of course, in the topsy turvy world of ultra-loose monetary policy, good news can actually be bad news for markets, because it hastens the advent of higher interest rates. This is the point at which the music stops and everyone has to find a chair, or suffer the consequences, which is why market prices are so sensitive to the arrival of this momentous inflection point. As a result, bond yields in the UK and the US have risen sharply this year, and we’ve seen a sell-off in technology stocks, where valuations are built on future profits rather than present cash flows. These taper tantrums have been going on to a greater or lesser extent ever since the extraordinary monetary response to the financial crisis, and we can expect them to continue now that central banks have doubled down on QE.
“Next week we shouldn’t expect any policy movement from the Bank of England, but we may well get some dovish commentary to soothe fixed interest markets. Rising bond yields pose a clear and present threat to the monetary policy path plotted by the Bank, and it won’t want markets raising interest rates prematurely. That would prompt painful cramps in the economy, as consumers and businesses struggle to digest the higher cost of borrowing. So the Bank will likely look to reaffirm its commitment to loose monetary policy for the long term and provide a reminder of the downside risks to the economy.
“However, the underlying reality is that the outlook for the UK economy has improved as a result of the success of the vaccine roll out and the short term support measures announced in the Budget. The positive economic spillover from the US stimulus package is the icing on the cake. The Goldilocks scenario is that the economy runs not too hot to cause rampant inflation and not too cold to cost livelihoods.
“While markets are clearly concerned about inflation, there are deflationary forces at work in the global economy as well. Improved technology, ageing demographics in developed countries, and the inevitable tax clawback that is coming to repair government finances will all help to keep price rises in check. Both the OBR and the Bank of England think that inflation will remain contained at around the 2% target rate in the medium term. So the central case is for interest rates to remain where they are for now, but for the first time since the pandemic struck the upside risks are building.”