The Bank of England will reveal its third Inflation Report of the year on Thursday 2nd August at 12:00 BST. The market is pretty much convinced that the BoE will hike rates, the GBP Overnight Index Swaps market is pricing in a rate hike this week with a 91% probability.
Usually when the market is so convinced of something the central bank responds. We believe that there is only a very remote possibility that the BoE won’t hike rates on Thursday. Due to this, the rate hike is the least interesting part of this Inflation Report. Of more concern are the following:
The mechanics of the rate decision: The includes the split between the MPC members, the market is currently expecting an 8-1 split in favour of a hike, with Sir Jon Cunliffe the only member expected to dissent and vote against a hike. However, if we get more MPC members voting against a hike then sterling could come under pressure, as it would suggest a future dovish stance by the BoE.
Economic forecasts: The BoE will also release its latest GDP and CPI forecasts for the next four years. There is not expected to be any change to the GDP forecasts, and the BoE is expected to confirm that it is looking for the UK economy to expand by 1.4% this year. Watch out for the CPI forecasts, global inflation pressure is rising and the UK is no exception, thus we expect the BoE to raise its CPI forecast for the entire forecast period. Higher CPI could be GBP positive if it coincides with a steeper UK yield curve.
The new neutral: Earlier this year the BoE Governor Mark Carney said that the Bank would give its view on the latest equilibrium, or neutral, interest rate for the UK economy. This is also known as R*. The market is expecting this rate to come in around 1.5%. If an R* of 1.5% is confirmed by the BoE, then it would suggest another three rate hikes are likely in the next 3 years. This would require a slight adjustment to current market expectations, which could be mildly pound positive. Obviously, anything higher than this could trigger a rapid increase in UK bond yields and a broad-based increase in the pound, and anything below this level could see a rapid decline in sterling.
The pound
As we mention above, confirmation of a rate hike is unlikely to be a market-moving event since the market has already priced in one rate hike from the BoE. Instead the update on the UK’s neutral interest rate is likely to be the most market-moving information in this Inflation Report.
GBP/USD has fallen sharply since the last report in May, and it is drifting lower as we lead up to the meeting. If the BoE can convince the market that the neutral interest rate for the UK economy is now 1.5% or above, then GBP/USD may start to recover, with 1.3285 – the base of the daily Ichimoku cloud – a key level of resistance, since a break above this level would suggest an end to the recent downtrend. A weaker neutral interest rate could make it hard for GBP/USD to sustain gains above $1.30, and trigger another leg lower in the pound’s downtrend.
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