(Bloomberg) -- The Bank of England may extinguish hopes of a shift to quicker interest-rate cuts this week after the budget reignited inflation concerns and triggered a selloff in UK bonds that evoked memories of the 2022 market meltdown.
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Economists and traders expect the Monetary Policy Committee to push ahead with only the second rate cut this year on Thursday, lowering the benchmark rate by a quarter point to 4.75%.
However, investors will be focused on whether Governor Andrew Bailey and his colleagues provide more cautious messaging on future reductions after Chancellor Rachel Reeves announced one of the largest fiscal loosenings in decades.
The meeting of the nine-member MPC is now a high-stakes event for UK assets after markets were rattled by plans to ramp up spending and borrowing to boost investment and public services. A dramatic repricing of rate expectations has left the BOE lagging further behind the easing cycles of the Federal Reserve and the European Central Bank over the next year.
“The market will be much more focused on whether there are signs that December is clearly in play for easing or not,” said George Buckley, chief UK economist at Nomura. “Higher growth and inflation should lead to a less dovish BOE.”
Prior to the budget, below-target inflation, and crucially a slowdown in services prices, had raised the prospect that the BOE could move to successive rate cuts in November and December. Bailey had also fanned speculation by saying the central bank could be a “bit more aggressive” if the good news on inflation continued.
But those hopes evaporated after Reeves shocked markets with her fiscal plans, which raised spending by £70 billion ($90.5 billion) a year on average. Tax rises cover little more than half the increase with the rest financed through extra borrowing — a recipe for inflation. While a BOE cut on Nov. 7 is still largely priced in, investors put the chance of another reduction in December at under 20%.
Reeves on Sunday sought to assure voters that she will not repeat the huge package of tax hikes, which were the largest in over 30 years. She said that she would “never need to do that again” and admitted that she was wrong to tell voters before the July 4 election that she would not announce new tax increases.
“I was wrong on the 11th of June,” she said on Sky News, explaining she underestimated the scale of the UK’s budget shortfall. “Just under a month after I said those words, I was taken into a room by the senior officials at the Treasury, and they set out the huge black hole in the public finances.”
With focus now turning to how officials on Threadneedle Street will react to the budget, Ales Koutny, head of international rates at Vanguard Asset Management, said even a move by the BOE next week is now in doubt, putting the odds of a cut at 50-50.
“It may now be that much of the bad news is in the price,” said Mark Dowding, RBC BlueBay Asset Management chief investment officer. “However, we struggle to build much of a bullish narrative, and we also retain a relatively downbeat assessment on the valuation of the pound.”
The budget sent the pound and bonds sliding. The yield on benchmark 10-year gilts ended the week at 4.45% — 21 basis points higher than five days earlier. It was the largest weekly rise since January. Two-year yields were up about 27 basis points on the week. The rout quickly spread to stocks and the pound, with the British currency posting its fifth straight week of decline against the dollar, the longest losing streak since 2018.
Many played down parallels with the market turmoil unleashed by former premier Liz Truss’s £45 billion package of unfunded tax cuts in 2022. However, the mere comparison is unwelcome for Prime Minister Keir Starmer’s new Labour government, which swept to power in July on a pledge to end the financial and political turmoil that marked recent years under the Tories.
The fact that the rise in gilt yields last week was most pronounced in the short-end of the curve contrasted with the Truss episode, where long bonds tanked. It suggests investors are concerned about how the budget affects the outlook for BOE rates.
“Ultimately, the budget will be too big for the BOE to ignore,” said Modupe Adegbembo, an economist at Jefferies in London. The scale of the fiscal giveaway “increases the risk the BOE skips the December cut and undermines Governor Bailey’s hopes of the BOE becoming more activist with rate cuts.”
The timing of Thursday’s MPC meeting presents a major communications challenge for Bailey, coming a week after the budget and only a few days after the US election.
The BOE is expected to provide its initial assessment of how the budget affects its projections. However, it is unclear whether the measures came soon enough to be incorporated into the BOE’s new growth and inflation forecasts that will accompany the rates decision.
The Office for Budget Responsibility’s verdict suggested that the budget policies added 0.4 percentage points to inflation at the peak impact in 2026. That is expected to bear down on living standards, which are predicted to only improve slightly from the last parliamentary term when they grew by the weakest on record.
“All the market moves that have happened recently won’t have come into the Monetary Policy Report, which is also a bit of an issue in terms of how you position the messaging,” said Andrew Goodwin, chief UK economist at Oxford Economics. “It is probably the worst timing they could possibly have, to be honest. There are so many moving parts.”
--With assistance from James Hirai.
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