Framing the ECB and BoE going forward

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Jeremy Stretch: Well, in a sense, we’re going back to one of the one of the themes that we identified in the context of the ECB and that comes back to policy sequencing or it or a bond purchase adjustments. Because of course, the Bank of England, much like the ECB and the Fed, have also been in the bond buying business in the post-crisis era.

Bipan Rai: Welcome everyone to another edition of the FX Factor podcast. Since the last episode we did a few weeks ago on China with Patrick Bennett. There’s been a lot of developments in the macro space, particularly in Europe. Indeed, we had two landmark meetings from the largest central banks in the region, the European Central Bank and the Bank of England. As such, I’ve invited my colleague Jeremy Stretch, who’s based in London, to walk us through why both central bank meetings were so important and what they’ll mean for the macro picture in the period ahead. Welcome Jeremy to the podcast.

Jeremy Stretch: It’s a pleasure to be here Bipan.

Bipan Rai: Excellent, so, of course, you know, the Bank of England hiked rates by twenty five basis points to take the official bank rate to fifty beeps or half a percent. And we’ll get into why this is an important level for the Bank of England going forward. But we’re going to start things off with the European Central Bank or the ECB. Jeremy, this ECB meeting was notable not because of the statement, but also because of what we heard from President Lagarde afterward with respect to inflation. Can you tell us what you said and why it’s so important going forward?

Jeremy Stretch: Yes, absolutely. I think it was a very interesting meeting and I think in the first instance, we have to remember that I think many in the market assumed that this meeting itself was going to be largely a placeholder event. It was merely going to be a meeting which was just setting the scene and was just a sort of a placeholder event ahead of the March meeting because the March meeting is going to be the one which is and was always going to be much more significant and much more pivotal. But the language that Governor Legarde used in the aftermath of the meeting did set us up for a very pivotal outcome coming into that March meeting because clearly she has set the scene for a potential adjustment in policy. And most importantly, it is very much the case that we are going to get updated forecasts at that 10th of March ECB meeting, and these forecasts will see a substantial upgrade in terms of the near-term inflation dynamics. That’s been, as I say, underlined by the language that has been used. And so that has really amplified market expectations of a potential adjustment in policy from the ECB coming substantially earlier than anticipated. So we went into the ECB meeting last week with the market thinking there could be a risk of a twenty five basis point hike by the end of the year. We came out of it after the rather more hawkish pivots from Lagarde, with the market preparing the ground for a twenty five basis point hike as early as September.

Bipan Rai: So what happened on the inflation front, really, that caused this sort of change in language from Lagarde and the ECB in general? Is there something there that we could point to as as cause for concern for the governing council?

Jeremy Stretch: I think the interesting point was that we had the release of flash high CP numbers for the eurozone coming out on the eve of this governing council meeting. And I think they really spooked the membership of the ECB board because far from actually seeing a degree of correction in terms of what had been a record level of inflation back in December. In December, we had annual inflation growth at five percent, so the market had assumed that there would be a small retreat or a modest retreat in terms of that annual rate of inflation come the January reading. But on the eve of the governing council meeting being agreed, we had an outcome of five point one percent. So a new record high in terms of inflation, and I think that really has caused the governing council to be a little bit fearful that there is going to be a much higher and more protracted inflation peak, largely due to the rise in energy costs. Now, of course, this is something which is a global phenomenon, but clearly we are seeing a substantive increase in energy costs, and those energy costs are perhaps even more pertinent in some of the economies of the eurozone, in particular Germany, because of the position of the energy market. So I think that has really caused the ECB to be increasingly nervous about the inflation backdrop. And I think if we go back to the staff forecast that the ECB last produced back in December for this calendar year, they assumed that inflation will be at three point two percent. Well, if we’re starting off the year at five point one percent, with the potential for further gains in the course of the next two to three months as energy prices remain elevated, those inflation forecasts are going to be materially missed, and I think that’s one of the causes of particular consternation being seen by the governing council.

Bipan Rai: Right. So let’s stick with inflation in the eurozone as well, because I think it’s such an interesting topic now going into this year, I think pretty much everyone would have said that if you look at inflation in North America and say, compare it to other places like the euro zone, given the amount of fiscal spending that we’ve seen in North America, you know, we would expect inflation to be a little bit more stickier here relative to the eurozone. And as such, that’s primarily why we might have been a little bit more dovish with respect to the ECB relative to the Federal Reserve. Now what is it about this, this global supply shock and central banks reacting to it? I mean, we get asked this question all the time, but I think it’s really important for us to lay out in this podcast episode why central banks are reacting to this, this inflation phenomenon and why these price pressures could be a lot more. Stickier than we originally thought.

Jeremy Stretch: That is a very good question, and I think one of the important factors from a European perspective and one of the reasons why I think markets were rather more reticent to price in a more aggressive reaction function for the ECB was the assumption that there would be a much smaller degree of fiscal impulse in the eurozone relative to the U.S., as you’ve mentioned. I think that’s notable. I think also importantly, the degree of wage growth or wage pressure is also apparently or appears to be significantly lower in the eurozone than it is in the U.S.. Although having said that, we have seen the unemployment rate falling across the eurozone to record low levels, and that could be indicative of some degree of wage pressure ahead. But we’re not seeing those substantive second round wage effects that we’ve seen thus far. And I think the other point that is still relatively significant as far as the eurozone is concerned is that although we have seen inflation trading to these new record highs, we have yet to see that being impacted by inflationary expectations becoming materially anchored from the target thresholds of the European Central Bank. So we still have those market based inflation metrics sub two percent. We have seen a brief flirtation around that two percent threshold, but they are still sub two percent. So we are in a scenario where, yes, headline inflation is exaggerated, it’s well above the target threshold. We are seeing still core inflationary pressures building as well, but we haven’t seen the same degree of second round wage effects yet, although we are continuing to monitor those very closely. And inflation expectations have yet to become materially anchored, and that’s one of the reasons why perhaps the European Central Bank were relatively relaxed about inflationary risks through the latter stages of twenty twenty one. But now I think belatedly have perhaps woken up to those, although waking up to those risks comes with its own inherent pressures.

Bipan Rai: Ok, so I mean, with respect to wage pressures, you mentioned the fact that market based indicators suggest that inflation expectations aren’t becoming too anchored. And of course, that’s the first thing we should watch for. No, not the first thing, but amongst the things that we should watch for when it comes to potential wage pressures. What about survey based indicators? Have the ECB flagged them in any sense as as cause for concern? Or are they somewhat grounded relative to what we’re seeing with the actual hike prints that you mentioned earlier?

Jeremy Stretch: Well that, I think it’s a very good question. I think we are going to see some degree of questioning as to whether there will be an uptick in terms of survey based inflation expectations because of course, we are all rational economic agents. And if we are seeing substantive price increases in our daily lives, then one would suspect that that will start to leak and influence the the survey based components in terms of inflation expectations. We will watch those in particularly in relation to from a market perspective in terms of the PMI surveys. I think that will be something that the central bank should and also the markets should monitor quite closely to see if there is going to be a substantive uptick in terms of those price expectations in the survey dynamics from that perspective. But I think for now, the, you know, the central bank have been spooked by the headline numbers. I think they are still monitoring the both the market and survey based inflationary pressures for signs of any any upticks. And I guess the other point to go back to the previous essence in a context of the wage dynamics. I think the European Central Bank will be watching the upcoming wage rounds and wage negotiations with a forensic degree of focus because of course, if there were to be any signs of an uptick in terms of those wage negotiations, that would also potentially amplify the ECB’s reaction function.

Bipan Rai: Ok. Humour me be a bit. Let’s say we do see those wage increases, obviously. Then it becomes important from an action perspective with respect to what the ECB will do. Now we’ve heard this mentioned time and time again from several different DCB speakers, especially Lagarde. But sequencing is very important when it comes to what the ECB is ready to tighten policy. And the first thing the Telegraph this number of times, including at as early as the December he should be meeting. But the first port of call is going to be to wind down the pandemic emergency purchases, or PEP, in March. And then after that, you know, can you lay out what the the next steps are for the ECB to tighten policy going forward?

Jeremy Stretch: Yes, absolutely. I think that’s one of the key questions that we would have or will have as we go into that March ECB meeting. Will the ECB consider adjusting their sequencing narrative because of course, they are still buying bonds? So at the same time as we’re talking and have been focussing on the Federal Reserve rowing back from their bond purchase programme, and we can touch on how the Bank of England are doing that as well. In terms of the ECB, they will still be purchasing bonds through the asset purchase programme after the expiration of the PEP emergency bond buying programme at the end of next month. And so they will be continuing to buy bonds. The question is how long will that bond purchase programme persist? Because of course, from an ECB perspective, one of the things that they do worry about alongside their primary remit in terms of inflation is this so-called fragmentation risk and what they mean. By that is the degree of dispersion between bond yields across the eurozone time horizon, because of course, the benchmark is deemed to be the German bond market, the bond market. And we do see latent differentials between the individual bonds of the nations of the eurozone and the German bond dependent on the broad credit worthiness and the economic conditions of the various nations. But of course, over the pandemic period, and obviously going back to the other previous eurozone crises, we have seen sporadic but substantive bouts of bond purchases from the European Central Bank, which has meant that they have been the effectively the buyer of last resort for these bond markets. So if the ECB are going to start rowing back in those purchases, then there weren’t may well be less demand and we start to see those differentials starting to build. And we’ve been seeing that in Greek government bonds and Italian BTP over the course of the last few sessions. So I think the ECB have a difficult balancing act. Yes, they would like to move away from this ultra easy monetary policy sequencing as part of that, so they need to roll back their bond purchase programme first, so they end the PEP programme in March. Then we move into the asset purchase programme of 40 billion a month. I think then the ECB may well look to try and taper that bond purchase down to maybe roughly 10 billion a month or so by the end of or towards the end of the third quarter and by the end of the third quarter, coming to a conclusion of those bond purchases, then allowing them to be in a position via sequencing of ending bond purchases first and then moving into a normal rate hiking cycle to consider that first hike in this cycle come the December meeting. So sequencing, I think, is one of the key dynamics that we will be focussing upon in the upcoming meeting in March to determine whether there will be any adjustment and how they will be trying to pursue the rundown in terms of their bond purchases.

Bipan Rai: So let me ask you this. Is there any chance that the sequencing of tightening changes? I mean, for example, will the ECB potentially be looking at hiking at the same time that they’re winding down their their asset purchase or AP programme?

Jeremy Stretch: Contacts of central banks? And since you make decisions, you can never say never. I think anybody who’s worked in the markets in the last decade or so would always be mindful of that. And I think in the context of the European Central Bank in particular, we have seen the bank proving to be remarkably innovative or sort of unusual in terms of its implementation of broader monetary policy. And of course, in the context of the Fed, we’ve seen a very exaggerated and accelerated profile of tapering. Moving to rate hikes or considering rate hikes and or quantitative tightening. Could the ECB conduct policy tightening at the same time as they’re still purchasing bonds? Yes, of course they could. Are they likely to? I think probably not. I think at this point, I think the markets have certainly put the ECB on a little bit of watch in terms of the context of the move out that we’ve seen in spreads over the course of the last few weeks. Roughly 30 beeps or so in the last few weeks between Italian bonds and German bunds, for example. And that’s just a little bit of a trigger point to say. I think that markets are mindful that they need to have a tapering process, and I think there will still need to be a small degree of differential between the conclusion of asset purchases and then moving towards monetary tightening via moving the deposit rate.

Bipan Rai: Ok, so we’re recording this on Wednesday, February 9th. And of course, I mentioned that because markets can be quite fickle in how they price central banks as of today. Jeremy, what do you see the market pricing in terms of ECB hikes for the rest of this year and also twenty twenty three?

Jeremy Stretch: Well, I think as we as we sit here now and on the 9th of February, we clearly are looking at a market which is roughly anticipating the ECB getting the deposit back back towards zero from its current minus zero point five percent. At this particular point now, I think it was interesting to go back to the guard on Thursday. Last week, when we had the ECB decision, she seemed quite happy to or tacitly acknowledged or approved pricing in a quarter of a point move in rates by the end of the year, but not the apparent 50 basis point differential that we’re seeing now, I think from the prospect of next year. So I think if we see a twenty five basis point hike from the ECB to take the deposit rate back to minus three point twenty five in December, I think we will probably find that the ECB will then cautiously but progressively move rates back towards zero into the early part of twenty twenty three and then start to consider moving back towards moderately into positive territory next year. I think it is going to be a very slow and progressive process. I think the ECB are not going to be in a position to move particularly quickly. And I think also we have to remember the fact that unlike the US, where of course, we are still talking about fiscal dynamics and the fiscal backdrop in the eurozone is going to be less stimulatory in 2022 and into 2020. Three then we saw over the course of the last 12 months or so, so I think that will also militate against the ECB being as activists as perhaps the market might like.

Bipan Rai: Okay. So our call for the end of this year is one twenty five basis point hike in the deposit rate in December. That’s correct, right?

Jeremy Stretch: Yes. So we’re looking for one move in December. Clearly, the the market, I think, has got a little bit exaggerated and is starting to price in a move as early as September. But I think going back to the conversation that I’ve just had about sequencing, then I think that would imply that the sequencing profile would need to be a little bit more aggressive than I would be prepared to countenance. I think the risks of a little bit of a sort of a pressure point coming up across the summer in terms of peripheral bond yields, and we should remember that liquidity and European bonds really dries up very significantly from sort of July through to the beginning of September. So I think if the ECB were to accelerate and exaggerate its tapering profile to perhaps end asset purchases before the summer, then I think there could well be a little bit of a blow out in terms of some of those peripheral bonds. So I think the ECB will be a little more cautious in terms of its adjustment in terms of asset purchases, so I wouldn’t necessarily be prepared to to countenance a rate hike as early as September. And I think it’s interesting because we have found that the governing council hawks have been a little more vociferous over the course of the last few weeks, clearly as a function of the increase in inflationary dynamics. But even a hawk such as class, not the Dutch central bank governor, even he isn’t on board with the idea and concept of the ECB being prepared to hike rates before the fourth quarter of this year. And I think that is probably a prudent assessment.

Bipan Rai: When we’re talking about rate hikes from the ECB. There could be an argument made that why not just reverse the prior cuts to the deposit rate? And of course, we remember them going in 10 beep increments at that point? Why are we suddenly talking about twenty five basis points? The other way is, is this primarily just a reaction towards how conditions have changed and how inflation has moved higher? And at what point do we go back to not just looking at the deposit rate as the benchmark, but actually looking at the refi rate, which is traditionally what the ECB used to adjust policy?

Jeremy Stretch: That’s I think that’s a good question. I think on the way down, we were in a situation where it became increasingly difficult as as the ECB were getting towards where they considered to be. The effective lower bound is to move rates to aggressively. So I think that’s where we ended up with a more of a sort of salami slicing technique of moving in 10 basis point increments prior to getting down to the the current trough of minus 0.5. I think the, you know, the recognition that the necessity to reverse policy is now sufficiently robust, that it probably does warrant twenty five basis point move, which in the context of the 10 basis point reductions, may seem a little ambitious. But going back to that point that the governing council have been spooked by inflation moving above five percent and or potentially going to move further into the top side during the first quarter, then I think it would warrant the ECB considering getting back towards zero in terms of the deposit rate as an appropriate strategy into the early part of twenty twenty three. I think also, you know, there is going to be the question about, you know, the reorientation of the policy dynamics as we move back into into positive territory. And I think as we get back into more normal interest rates with a positive dynamic into the course of twenty twenty three, then perhaps we will get back to more traditional assumptions in terms of looking at policy coming via the rate rather than being focussed on the deposit rate, as we’ve been focussing on as we’ve moved down to those all time lows in the post-crisis period.

Bipan Rai: What does this mean for the euro on balance for the rest of this year. What levels are we looking at for Q3 and Q4?

Jeremy Stretch: It’s interesting. So we have we have found that, you know, investors have been starting to rebuild euro long positions over the course of the last few weeks prior to this sea change adjustment from from the ECB. So in a sense, it could well have been the case that some of the real money managers were already anticipating. There could be a slightly earlier turn in the ECB’s rate cycle. I wouldn’t be surprised in the near term if we are going to see markets being very mindful of the degree of upgrade in terms of the forecast profile into the March meeting that we could well find that the euro gets back through that one 15 area and gets up towards a sort of a one 16 handle. Although I think once we get above one point fifteen and a half, it will prove to be a little bit more challenging in terms of anticipating and extending further euro gains. But I think as we go through the rest of this year, I think the realisation will come through that, although we may have a tightening bias being in place from the ECB and we may well have that reduction in bond purchases, I think there is still a case to be made that there is still a growth, stronger growth narrative and or a stronger tightening bias from the Fed that will, which I think will still be appropriate and still be pertinent through the course of the latter stages of next year. And I think the eurozone despite its. An inflationary spike, I don’t think it necessitates, you know, sort of all needs a substantially sort of cheaper euro, but I think we will find that the euro will drift back lower and through the latter stages of this year. So I wouldn’t be surprised if we heading back towards a Level one twelfth trough. But I think that will provide the sort of the near-term base. I think we’ve certainly seen a higher profile in terms of euro dynamics than perhaps we would have otherwise had anticipated prior to this sea change policy pivot from Lagarde the most recent meeting.

Bipan Rai: Ok, so I mean, why don’t we switch gears and talk a bit about the Bank of England now? I mean, we could continue to go on about the ECB for that could be its own podcast episode. But I mean, the Bank of England is is particularly interesting given the fact that they’ve been so blunt when it comes to their guidance and not just on rates, but also on quantitative tightening and the like. So we saw a rate hike last week, the second consecutive meeting in which we’ve seen the Bank of England hike rates and now the bank rate is at half a percent or 50 basis points. Why is it such an important level for the Bank of England, Jeremy? Can you explain that or detail that to the audience? 

Jeremy Stretch: Well in a sense, we’re going back to one of the one of the themes that we identified in the context of the ECB, and that comes back to policy sequencing or or a bond purchase adjustments. Because of course, the Bank of England, much like the ECB and the Fed, have also been in the bond buying business in the post-crisis era. And so the Bank of England have accumulated gilts to the tune of eight hundred and seventy five billion pounds. They’ve also additionally bought 20 billion of corporate bonds. Now, the Bank of England had previously post the global financial crisis had some rules in terms of sequencing, which ultimately only really came into place once we were getting rates to nearer 1.5 percent. But the bank under Governor Bailey recalibrated those sequencing dynamics to conclude that when the bank rate reached zero point five or 50 basis points, then that was the first trigger point for reductions in terms of its balance sheet. Because what the Bank of England have now triggered by hitting that to 50 beeps threshold last week is that they will no longer be reinvesting the proceeds of maturing gilts. Now that’s quite significant because that will see a substantive reduction in terms of the size of the balance sheet. Roughly 70 billion will be reduced from the balance sheet by the failure to reinvest maturing gilts between this year and the end of twenty twenty three. And if you were to extend that profile out to the end of twenty twenty five, then the holdings of gilts would be reduced from the current eight hundred and seventy five billion by almost one hundred and ninety five billion. So there is a substantive reduction coming in terms of the Bank of England’s balance sheet. And Governor Bailey has been quite explicit in so much that he is aware that in the modern era of ultra low interest rates, that even in this interest rate cycle where the current terminal rate for the Bank of England is probably around 1.5 percent, there does need to be a degree of room and latitude being built into the bank’s balance sheet in order to facilitate an ability for the bank to utilise it once again when the next downturn inevitably comes.

Bipan Rai: Ok, so that’s a good point about the terminal rate in the UK. Now what we saw in the last cycle, though, was that they only really topped out at seventy five basis points or three quarters of a percent. Why is the terminal rate higher this time around, given the fact that over the prior a couple of rate hike cycles, really we’ve seen a progressively lower terminal rate?

Jeremy Stretch: That’s true. I think we’re still in a scenario where I think we have to remember that the UK does have an inherently higher inflation profile and susceptibility than perhaps that we see in other markets. But I think there is still a question mark about the bank’s ability in order to take rates substantially higher. We have or the UK did have a very, very elevated degree of consumer leverage coming out of the 2008 crisis, and I think that did preclude the bank from being able to move rates substantially higher even in the post global financial crisis world. I think this time around there is and will be more of an ability for the bank to adjust policy progressively higher. But I think what we have seen is that, yes, consumers have materially rebuilt their balance sheet during the COVID era as they’ve been forced to preclude from spending. But I think we are still in a scenario where there is a dislocation between the market’s assumption of the terminal rate somewhere close to one and a half percent and the market’s interpretation of the Bank of England taking rates to well beyond that before the end of this year. And I think that’s certainly where there is something of a disconnect.

Bipan Rai: So you brought up a good point. Now, the Bank of England is at 50 basis points. They’ll stop reinvesting their maturing assets on their balance sheet. That’s what we refer to as passive. But you know, Governor Bailey has mentioned also that once the bank rate gets to one percent, they’re going to switch gears again when it comes to quantitative tightening. Can you detail what that means to our listeners?

Jeremy Stretch: Indeed. So you’re absolutely right. So we are in a phase of passive duty now. So the non reinvestment, but the next element of the next leg of the sequencing profile from the Bank of England’s perspective occurs when rates reach one percent, so another 50 basis. Points higher, so the potential if we’re moving in twenty five basis point increments. Now I know that for members of the Bank of England did vote for an immediate 50 basis point hike at the last meeting, but I think still we will be looking ultimately at twenty five basis point increments. So after the two additional hikes, the Bank of England will then consider actively selling gilts from the balance sheet back into the market. Now this is very much a case of the bank will consider that process once they reach one percent. It’s not an absolute inherent trigger point, but I think it’s likely that the bank will be moving to consider that process to begin. I think when the bank put in place this sequencing rules, I think the baseline presumption would have been more likely than not that we wouldn’t be actively looking to sell bonds back or the bank would be actively selling bonds back into the market until twenty twenty three. But if we’re right on our baseline assumption of hitting one percent by August, then I think we could well be looking at a Q4 scenario where the bank is starting to drip feed bonds back into the market. Now, of course, that will potentially add to the upside risk in yields as we are going to see once again that reversal of buyer of last resort from a central bank. And so that will have some implications for the shape of the curve. But I think as long as the economic conditions are relatively stable, and of course, that would be most likely a baseline assumption. Once rates have been hiked on two more occasions, then we are in a position where the bank will consider actively running down the four hundred and forty billion of gilts that it has purchased in the COVID era. So eight hundred and seventy five billion is the total level of gilts going into the passive duty four hundred and forty billion of which have been brought since the arrival of COVID. And I think the bank would like to work down that that overall total reasonably substantially through twenty twenty three. As I say, in order to facilitate room on the bank’s balance sheet for the inherent next downturn.

Bipan Rai: So you bring up a really good point when it comes to once we get to one percent level in the bank rate that the bank might consider actively selling its its gilt holdings. I think this is monumental because since the QE era began, I mean, we’ve never seen a central bank actively sell its its asset holdings. And really, it remains to be seen how the market will digest that. One thing I did, you know, we did kind of notice with respect to passive in the in the United States is that, you know, there was a bit of a term premium built in longer dated yields, you know, that was taken back quickly. But you know, does that change somewhat now that we’re actually seeing the central bank move towards, you know, simple simply halting reinvestment to actively selling its holdings? I mean, does that change and what could that mean for cross asset markets, do you think?

Jeremy Stretch: I think you’re absolutely right to underline the fact that we could potentially be moving rather more towards uncharted territory. I think we have been in an environment where we have been in a sort of a bond purchasing environment during crises, going back to the legacy era of 2008. But ultimately, we’ve not seen the substantive active running down of those bank balance sheets. And I think it is going to be an interesting dynamic as the as the bank is likely to consider that. And I think one of the more important points that I would say from a market perspective in terms of the UK rate profile is that once we reach one percent, I think it then becomes more of a challenge for the market to consider. The bank will immediately follow through with additional policy tightening because I think to tighten policy aggressively at the same time as the market is being forced to digest potentially a drip feeding of bonds back into it in an unprecedented fashion, I think is rather ambitious. So I think there will be a protracted and prolonged pause once the Bank of England reaches one percent. But you’re absolutely right there is going to be this question mark as to how the sort of term premiums are going to play out. And I think, you know, as if and when we get to this active duty, I think markets will be looking for the first movers in this active space to see how that will potentially interpret how other markets will be influenced as we as we move forward. As this broad reduction in terms of balance sheets plays out as we as we move into a similar sort of trajectory from the Fed. So I think we will certainly be looking at term premiums relatively closely as a consequence of that.

Bipan Rai: Ok, OK. So given that the Bank of England is juggling a few tools here now, right with the hike in the in the bank rate and also with respect to unwinding its its quantitative easing programme through Q, how long should we wait between a rate hike and then potentially being underway and then successful rate hikes thereafter? I mean, should there be a bit of a pause in between or can they do both at the same time effectively?

Jeremy Stretch: I think there will be definitely and definitively a pause between the reaching of one percent, then the adjustment into active consideration of selling gilts back into the marketplace and or the next rate hike. So I think there will be a pause. So, you know, if we if we get to one percent come the August meeting, I think as we move then into Q4, I think the bank will. And start to look at the consideration of selling bonds back into the market, but I think we’re looking at potentially a sort of a six month window, at least between reaching one percent and or any move in terms of additional tightening beyond there. So I think there is going to be certainly a degree of pause in terms of the policy spectrum. And that takes me all the way back to the beginning point that we’re currently sitting here on the 9th of February, with the market pricing in approximately five additional hikes from the Bank of England through the calendar year 2020 to. Now there are only indeed seven Bank of England meetings through the rest of this year. So if we are still sticking to those twenty five basis point increments, the market is assuming that five of the seven meetings will see rate hikes. I think that’s hugely ambitious. I think if we get to one percent by August. Now there is a small residual risk that it could happen as early as May, but I think it’s more likely to be August, then I think we will see a at least a six month pause after that in order to allow the Bank of England to to work through the mechanics of the whole process and start to drip feed gilts back into the market and ultimately to see what the market’s reaction function is. Because I think that’s going to be hugely symbolic, and I think that will certainly determine whether the bank are then forced into a slightly more protracted period of pause. So I think it seems unlikely and unworkable to assume that we’re going to be heading back towards the terminal rate. As I say, roughly nearer, you know, around the 1.5 percent threshold until the latter stages of twenty twenty three.

Bipan Rai: So the risk is that window shrinks, right? What causes that window to shrink, potentially for the Bank of England?

Jeremy Stretch: So I think if we’re going to see a shorter period between reaching one percent and the next interest rate move, then I think that would definitely be a function of the fact that inflationary pressures would have to be much more pronounced and protracted than the Bank of England are currently perceiving or anticipating. Now, when we had the rate hike last week, that was accompanied by the fact that upgraded forecast in the Bank of England had a new inflation peak of seven and a quarter percent in the second quarter of this year. But over the three year forecast profile, that would be a substantial retreat in terms of the inflation dynamics to such an extent. At the end of that forecast, profile inflation was only forecast to be one point six percent. That actually will be the lowest forecast since 2011 in that particular remit. So that implies that if we are going to see a compression in terms of the rate hiking profile, then I think those Bank of England’s assumptions that inflation is likely to fall very significantly over the forecast profile. I think you would need to see that challenge and challenge quite significantly. I think that would either imply that you would need to see energy prices proven to be much stickier than perhaps markets are giving them credit for. But more importantly, I think the other overarching issue which I think the Bank of England will be very mindful of is the risks of a degree of a wage price spiral. And I think that’s why the Bank of England will continue to monitor wage growth very closely over the course of the upcoming months. The bank’s regional agents are an important part of the information gathering in that regard, and they will be monitoring those wage negotiations over the course of the next few weeks and months very closely. And if there is a sign that there is wage growth without the commensurate increase in productivity, then I think that will be the potential catalyst which could shorten the time horizon between reaching one percent in the next rate move.

Bipan Rai: Ok, so let’s go through some rapid fire question. Let’s start with the Bank of England for the rest of twenty twenty two. How many times do they hike rates?

Jeremy Stretch: Two hikes through the rest of the twenty Twenty two to one percent.

Bipan Rai: And for twenty twenty three, what are you expecting?

Jeremy Stretch: I think they will probably put in another couple of hikes. I think it’s going to be a slow and progressive process taking us back towards that sort of term on a rate level.

Bipan Rai: What is the terminal level for the Bank of England’s balance sheet?

Jeremy Stretch: The terminal level for the Bank of England’s balance sheet? That that’s a rather more difficult level to quantify, but I think the bank would like to see a reduction at least half of the bonds that they purchased post the COVID pandemic. So half of the four hundred and forty billion within the next two to three years.

Bipan Rai: For the sterling against the US dollar. What are you expecting that level to be at the end of Q2?

Jeremy Stretch: I think we will see Sterling underperforming against the US dollar over the course of the next quarter or so. So I think we will be heading back to a one thirty one point thirty three area from current levels.

Bipan Rai: For Q3 and Q4. What are you expecting?

Jeremy Stretch: I think it will also be a case that Sterling, I think, will continue to struggle somewhat. So I think it is going to be the case that we are going to remain in that sort of low 130 area. So I think it’s it’s difficult to see a rationalised justification for for Sterling being anywhere near above the sort of one point thirty five level. So I think it’s going to be definitely a sort of a one point thirty two, one point thirty three period for the latter stages of this year, unless the bank proves to be much more activist than we’re forecasting.

Bipan Rai: And finally, on the political side of things, what can we expect with respect to a possible leadership challenge to Prime Minister Johnson?

Jeremy Stretch: Well, as of the 9th of February. Prime Minister Johnson is still in situ, and he has not been challenged for a vote of confidence in his leadership of the Conservative Party, but it looks highly probable that there will be a challenge. I suspect by May we have local elections here in the UK on the 5th of May, and if the Conservatives perform poorly in those as the opinion polls would suggest they will under current circumstances, then I suspect we will then find that there will be a no confidence vote triggered and we may well find there’s a new leadership race being run in the June-July period. I think if the current chancellor, Rishi Sunak, is maintained as the lead candidate for any change in leadership of the Conservative Party and de facto the UK government, then I think he would be potentially perceived as a fiscally responsible steward of the UK economy, and I think that would provide some degree of support for Sterling. But ultimately, we invariably find that when there are political risks, then that’s usually witnessed through a weaker value of sterling against the US dollar.

Bipan Rai: Ok, that was good to be my next question as to whether or not the market should worry about that, but you pre-empted me. So that’s that’s good. Look, we’ve covered a lot of ground. Thank you so very much for taking the time to join us today to talk a bit about the ECB, the Bank of England and and also what you’re expecting for those markets. We’d love to have you back.

Jeremy Stretch: It’s been a great pleasure. Thanks very much for your questions, Bipan.

Bipan Rai: Excellent. And thank you all for listening. Don’t forget if you haven’t done so already, you can subscribe to this podcast and all the usual platforms that’s Apple, Spotify or Google. We’ll see you again next time.

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