Bank of England Preview: Soft Landing?

Bank of England (BoE) policymaker Martin Weale said last week that UK inflation may prove more persistent than expected, hinting that it is unlikely the economy will require a further stimulus once the current round of asset purchases ends. He pointed out that higher oil prices and potential wage pressures as the economy recovers “suggest a risk that there may be more persistence to inflation than one might expect at a time of rising unemployment and weak demand” and added furthermore “I do not think there is likely to be a further case once our current programme is complete”.

This is by far the most explicit indication by an official that the MPC’s £50bn increase in stimulus in February could be the last. Paul Fisher noted two weeks ago that the risk of the UK slipping into recession may have been avoided and if a positive trend continues, “that would put more weight onto the argument for stopping rather than carrying on with gilt purchases”.

Does this mean the printing press is about to be turned off soon? Not quite. The economy is recovering only slowly and unemployment remains too high. Inflation is coming down and the BoE’s main projection is still for CPI to fall below the 2% target by the end of the year. Our BoE base rate indicator clearly indicates that more QE is under way (see next page).

Weale, together with Chief Economist Spencer Dale, had to back down last year after having argued for rate hikes in H1 11, so we know he has a hawkish bias. Two members – Adam Posen and David Miles – actually preferred a higher ceiling for asset purchases at the last meeting. So after having been united for a while, the MPC now appears to have become somewhat split again. The May MPC meeting will indeed be interesting – we still go for another £50bn increase in the asset purchase target to a total of £375bn but a £25bn increase could also be an option to signal a “soft landing”, which was what the MPC did in November 2009 (see Research UK: Why the BoE is likely to do more QE in May, 23 February).

Trade ideas
Despite seeing more asset purchases announced, we think the short sterling curve is a bit too flat further out. Specifically, we favour reds over greens and spreads can in our view widen decently. We believe the Bank of England will deliver its first 25bp rate hike in February 2014 – here the market agrees with us – but furthermore see room for additional tightening after that. We find it hard to believe that after increasing the base rate by 25bp in February 2014, the BoE will hike only once more in December the same year.

We recommend buying short sterling Sep ’13 and selling Sep ’14 at 32bp for a first target of 50bp and with a stop at 22bp. We consider this a low-risk trade, as when recession fears peaked in December last year the spread narrowed only to 20bp. The economic outlook has improved since then. Alternatively, we like the equivalent December spread at 35bp.

With the Bank of England’s current purchase strategy, we see more support to shorter dated Gilts and less support to longer dated Gilts compared with the buying from October to January (see Flash Comment: BoE does another £50bn QE – buying strategy changed, 9 February).

As a result, we see scope for curve flattening, specifically the 5-10 year swap seems very high at 84bp. In the 10-year period up to the financial crisis, this spread was zero on average (highest 46bp, lowest -55bp), while after the crisis it has been 65bp on average (highest 113bp, lowest -54bp). We recommend selling this spread down to 55bp, stop at 99bp.