Views from the LDI desk – August 2024

Bank of England: Both tightening and loosening?

The Bank of England (BoE) announced a 0.25% cut to interest rates on 1^st August with the decision passing by a narrow 5-4 majority, taking the base rate to 5%. Services inflation and wage growth, two elements that the Monetary Policy Committee (MPC) have been highly focussed on remain elevated, although dropping, but with CPI inflation back at 2% for two consecutive months enough of the MPC members felt it was time to start easing the restrictiveness of policy.

This decision is also supported by the latest data from the Decision Makers Panel survey, which showed that expectations for wage growth, inflation and hiring conditions were all easing for those companies surveyed.

Wage and price expectations for the year ahead have continued to trend lower….

…while tight conditions in the labour market have continued to ease off

Outlook for short-dated rates

This first cut is not necessarily indicative of deep and continued cuts to come – if anything a lot of the messaging from the BoE was at pains to highlight the continued upside risks from lingering domestic pressures in the form of second round effects driven by continued high wage settlements.

Headline inflation has recently been flattered by base effects in energy

With inflation expected to tick higher later this year as the negative contribution from petrol and energy prices caused by year-on-year base effects drops away, while services inflation remains elevated, the language in the Monetary Policy Report was particularly cautionary, for example:

“In balancing these considerations, at this meeting, the Committee voted to reduce Bank Rate to 5%. It is now appropriate to reduce slightly the degree of policy restrictiveness. The impact from past external shocks has abated and there has been some progress in moderating risks of persistence in inflation.”

“Monetary policy will need to continue to remain restrictive for sufficiently long until the risks to inflation returning sustainably to the 2% target in the medium term have dissipated further. The Committee continues to monitor closely the risks of inflation persistence and will decide the appropriate degree of monetary policy restrictiveness at each meeting.”

Our sense is a majority of the MPC really wanted to get this first cut in before inflation ticks higher again, but they remain nervous about how quickly services and wage inflation will dissipate. While the market was quick to price further cuts on the back of the news, we remain cautious on how quickly the MPC will be able to deliver further cuts. A 5.5% increase in public sector wages was waved off by Governor Bailey as not having the same impact as private sector wage increases, particularly if funded by tax rises, but ultimately the money will still find its way back into the economy and arguably this sector of the population has a higher propensity to consume than those who may be impacted by potential increased capital gains taxes in future.

Market has priced in deeper cuts after the announcement, despite the notes of caution

Wider market reaction

Market reaction at longer tenors was robust, with 10yr yields falling 10bps at one point in the hours after the announcement, cementing the path back below 4% on the 10yr gilt that the market had been flirting with towards the end of July.

With front end yields dropping rapidly the long end struggled to keep up and the 10s30s yield curve continued its recent steepening journey. As we cover in the next section, with bond sales from the BoE and high expected issuance from the DMO, we continue to hold the view that curve steepening pressure and greater term premium will persist.

Gilt yields fell and the yield curve steepened after the announcement

Quantitative Tightening and the borrowing outlook

While the BoE won’t take a decision on the next 12 months of Quantitative Tightening (QT) until September, The Monetary Policy Report included some interesting snippets on their views on the QT programme. Of particular interest was an acknowledgement (see bottom of page 25) that if QT was deemed to be causing excessive tightening of financial conditions (selling bonds back to the market removes cash from the financial system) then this could be offset by cuts to the base rate given there is plenty of room to cut.

Combined with the recent ‘Let’s get ready to repo!’ speech given by Victoria Saporta from the BoE Markets Directorate that set forth the bank’s plans to continue to expand repo provision to banks to manage reserves, it increasingly looks like we may see a Quantitative Tightening forever scenario. Or at least until the bank runs out of bonds to sell, which at current pace would be around about 7 years. The BoE look likely to be both tightening and loosening conditions at the same time in the coming year.

Next year sees a lot of bonds held by the BoE mature, so the update in September will confirm whether they plan to do active sales to top the balance sheet reduction up to £100bn or go further than this and maintain similar levels of active sales as they’ve made in the last two years, which would put further pressure on longer dated gilts unless changes were made to where on the curve bonds were sold.

Year ahead sees a lot of bonds held by the Bank of England mature

Given the recent update from Chancellor Rachel Reeves on a £22bn ‘black hole’ in the government finances for the year ahead, it is reasonable to also expect a Debt Management Office remit revision to come after the budget is delivered on 30^th October. While Reeves has already found savings to close some of the gap and is widely expected to increase some taxes to cover other elements of the shortfall, it appears likely that some of the need for the coming year will be funded by additional borrowing. This could easily be a further £7-8bn of gilt issuance on top of an already record gilt remit.

Key takeaways

• This was a marginal and hawkish cut – the BoE were at pains to flag the upside risks from here.
• While data continues to show signs of softening price pressures and labour markets, policy announcements such as public sector pay deals at 5.5% mean upside risks persist and the pace of cuts now priced into the market may be difficult to deliver.
• It looks likely that active QT will continue – we will get clarity in September but all the indications point to the BoE planning to continue to run their gilt holdings down.
• The supply of gilts to the market between the Government and the BoE shows no signs of slowing, supporting our view that longer dated yields may continue to struggle vs. shorter dated rates as we enter a cutting cycle (although possibly slower at the very front end than markets currently predict), steepening the curve and increasing term premium.

The opinions expressed are as of August 2024 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.

Risks

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Past performance is not a reliable indicator of current or future results.

Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.

Important information

Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Tel: + 44 (0)20 7743 3000. Registered in England and Wales No. 02020394. For your protection telephone calls are usually recorded. Please refer to the Financial Conduct Authority website for a list of authorised activities conducted by BlackRock.

Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.

This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer.

© 2024 BlackRock, Inc. All Rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, iSHARES, BUILD ON BLACKROCK, SO WHAT DO I DO WITH MY MONEY are trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners.