1 May 2024: The BoE tweaks its QE losses

There were two conflicting reports published yesterday about the UK housing market. The first was more anecdotal and opinion-based and declared that the market is now more affected by high interest rates than ever in the past twenty years. However, the other, which contained hard evidence on mortgage approvals, showed that the market is at its most buoyant since September 2022.

It is possible that both reports could be correct. At some points, the current level of interest rates will deter borrowers from “taking the plunge”, but for now, equity levels are high and potential buyers are content to “cash in” before prices begin to level off.

There will surely be a surge in house buying and therefore house prices when the Bank eventually cuts interest rates. House prices are not included in Consumer Price Inflation figures, but many of the ancillary costs are in the “basket”.

It does appear that currently “all roads lead cash hinges in monetary policy.” The financial market goes through cycles where there is one specific topic that overrides all other factors. In recent times, Theresa May’s minority Government was closely followed by Brexit.

The Pandemic caused havoc in the market, as did the arrival of a vaccine and the amount of fiscal support that was pumped in by Chancellor Sunak, including the highly inflationary “eat out to help out”.

As the country emerged from the Pandemic, the rush to spend as shops reopened stirred up inflation to its highest level in years. This in turn caused the Bank of England to raise interest rates. This drove economists to question the pace at which rates were rising, believing that a series of twenty-five basis point increments would simply prolong the “agony”.

While this assumption may have been correct, other G7 nations where rates were hiked more quickly have seen inflation remain “sticky” and have prevented them from cutting rates. Once inflation was beginning to fall, several Central Banks paused and then halted their cycle of interest rate hikes, leading the market to the situation that currently prevails and has since the beginning of the year, prompting the question; when will the first rate cuts take place?

Once rate hikes have begun it may well be politics that is the “next cab off the rank”, with elections due in the Eurozone that will begin on June 6th, coincidentally, the same date as the majority of market practitioners believe that rates will be cut, followed on a date that is yet to be determined for the General Election, and then the U.S. Presidential Election.

2025 will have inflation at its core, particularly in the first half of the year, since rate cuts are likely to see consumer prices begin to rise again.

There are overarching concerns about the geopolitical situation, with two major conflicts taking place that could easily escalate. The Russian invasion of Ukraine may be measured in years, not months since there appears to be no end in sight after twenty-six months.

There may be an end in sight to the Israeli action in Gaza. Hamas is considering another proposal for a ceasefire, but even as they stop shelling, the region remains a tinderbox.

May is likely to be the month when the Central Bank’s monetary policy becomes a little clearer. The MPC meets on May 9th, and while there is considered little chance of a rate cut following this meeting, there may be a little more advance guidance handed down about when cuts may start.

The pound ended the month on the back foot, losing ground over the final two days of April. Yesterday, it fell to a low of 1.2472, closing just one pip higher.

There is still a degree of confusion within the market over the possibility of a soft landing for the economy. The definition of a soft landing is when an economy slows from rapid growth to moderate growth, while the rate of inflation falls in unison. The effect on inflation and GDP is driven by interest rates.

As rates begin to rise, inflation slows down as demand weakens which drives weaker overall GDP when rates reach their peak, inflation is usually controlled, but the economy can be close to recession.

This was seen in many G7 economies over the past year. The Fed was particularly aware that it was driving the U.S. economy towards a recession, while the ECB was far less worried, given its more radical concern over inflation.

In the UK, the Bank of England was aware of the issue of a recession but believed it to be a risk worth taking for inflation to be defeated.

Since it paused and then ended the cycle of interest rate hikes, the Fed has hinted on several occasions about a date when rate cuts may begin but has “pulled back from the brink” on several occasions as inflation has become sticky.

The stickiness of headline inflation that seems unable to break the 3% level is bringing into question the notion of a soft landing since popular opinion seems to dictate that it can only be declared once inflation has reached the Fed’s 2% target.

This is looking increasingly likely to be impossible to achieve since the economy is showing signs that it is slowing down which may well facilitate a rate cut and the end of falling inflation.

Since a soft landing has been a rare occurrence which is impossible to categorically confirm, the only possible time it has happened was in 1994. In other possible “sightings” inflation has only fallen to its target when the economy is either in recession or has seen high unemployment.

With employment still vibrant and GDP currently the strongest in the G7, inflation is unlikely to fall much further without a tightening of monetary policy.

Today’s meeting of the Fed is expected to retain its hawkish bias with no mention of a rate cut happening before September. The market focus will be on any change to the dot plot. Since the traders are unable to determine when the first cut will take place, it may be able to resolve how many cuts there are likely to be going forward.

The dollar index saw a bout of position squaring, as the end of the month coincided with the beginning of the FOMC meeting. It rallied to a high of 106.43 and closed at that level. This was its highest monthly close since October last year.

The ECB finds itself in a quandary. It is not yet able to declare victory in the war against inflation but is increasingly likely to sanction a cut in interest rates at its next meeting, which takes place on June 6th.

In keeping with other G7 members, the fall in headline inflation appears to have come to an abrupt halt.

It may well be that the makeup of the global economy is no longer conducive to an inflation rate of 2%. Geopolitical conditions may make Central Banks within the group of industrial nations, be that G7, G9, or G20, finally come to terms that it is not workable to have an inflation rate of 2% given globalization.

With every developed economy being interconnected and every developing nation being dependent to some degree, on those developed nations inflation whether it is due to war, weather conditions or natural disasters will be a constant that is more reliable than the level of growth.

The ECB faces further complications since it is trying to create a single monetary policy for twenty individual economies which is about as difficult as “herding cats”.

Until there is a greater sense of coming together in the Eurozone, possibly fostered by an agreement on fiscal union, there will always be outliers whose economies are simply not conducive to low inflation.

Nations where they are unable to grow sufficient crops anywhere close to self-sufficiency or can export goods to make up the shortfall. Their imports will be subject to global conditions, which makes them dependent for a whole range of reasons.

In the next few years, the G7 will probably raise their targets for inflation to either 2.5% or more likely 3%. While many, probably led by the U.S., particularly if Trump wins the election, will say that all that is happening is that “the goalposts are being moved,” and a target for inflation needs to be close to unattainable, it is still likely to happen, although the U.S. may abstain.

The reaction of the Eurozone to such a proposal will be interesting since it will show the degree to which Germany can exert its previously held dominance.

There may be a trade-off between the target rate for inflation and the reintroduction of a less onerous set of budgetary conditions.

The Growth and Stability pact has been “dead in the water” since the Pandemic and needs to be replaced by a fair and workable solution which allows nations that have seen both public debt and budget deficits balloon have an opportunity to get back in line.

The Euro had a relatively stable April which saw it decline but only moderately. It fell to a low of 1.0601 and closed at 1.0666.

Have a great day!