Bank of England rate hike 'will be pushed back' by election result

After Theresa May's decision to call a snap election backfired with the Conservatives losing their parliamentary majority, the increased political uncertainty is likely to push back a first Bank of England interest rate hike to the first half of 2020, economists and strategists in the City said on Friday.

Markets have been pricing the first BoE hike of 25 basis points at around the middle of 2019 but are likely to push this back to the first half of 2020, said Deutsche Bank fixed income strategist Jack Di-Lizia, which is in line with the richest levels of yields seen in advance of the central bank's May Inflation Report.

"The slope of the money market curve will likely bull flatten in response given the directionality with the outright front end rally, although here the path of the FX will be a key variable," he wrote in a note on Friday morning.

HSBC chief European economist Simon Wells said he saw no immediate reason to change his forecasts for monetary policy, not predicting any hike until 2020 either.

"Given our muted outlook for growth and domestic inflationary pressures (as opposed to a temporary bout of imported inflation), and risks associated with Brexit, we do not expect the Bank of England to raise rates for the whole of this year or next."

Macro brains at Citi felt the final election result is likely to see "GBP modestly weaker, modest upside risk for gilt prices and modest downside risk for UK shares", taking the tack that "avoiding nationalisation risk, higher corporate tax risk and concerns over economic direction", which it saw as the main outcomes of a Labour victory, "are net positives from a UK equity market perspective".

Nomura added that if the pound continues to fall or remain not far off its lows, could result in higher inflation and also increase the downside risks to consumer spending.

"The result is likely to be weaker private domestic demand growth," the Japanese bank's rate strategists opined. "This is not an environment in which we think the Bank of England would feel comfortable removing accomodative policies and reinforces our forecast of no rate hikes until end-2019 (and, even then, these would be conditional on the Brexit deal that is on the table)."

SOFTENING BREXIT DIRECTION

While the Conservatives’ decision to call an election was framed around increasing Theresa May’s majority to give her a stronger hand in Brexit talks, DB's Di Lizia felt that in the coming months there is potential for the election result "to lead to a softening in the Brexit stance given the electorate’s rejection of the Conservatives’ policy together with increased push back against increased fiscal tightening".

Although these drivers would see more bearish rates, he felt in the short term at least "the market is likely to focus first on pricing increased political uncertainty as the market digests the formation of the new government together with the potential for new Conservative leadership. This suggests bullish rates price action should dominate initially."

While his pre-election prediction argued that a reduced Conservative majority would generate bullish pressure on gilts, pointing to a rally of around 10bp in 10-year yields, Di Lizia said the significant uncertainty that still remained on Friday morning meant the path of yields "depends on the extent to which the market focuses on the bullish impact of increased political uncertainty and the potential for a repeat election versus the likelihood of any softening in the approach to Brexit or increased fiscal policy a new government may take".

HSBC's Wells agreed that the range of Brexit possibilities had widened, with the election having shown voters were still split between two very different visions: a high tax and spend economy with the door open to a softer Brexit, or a continuation of fiscal consolidation and the 'hard' Brexit outlined by Theresa May.

"In the end, the country looks to be split right down the middle – with no clear mandate for either vision. Its weaker position means the government is more vulnerable to rebellion from its own hard-line backbenchers, which could scupper a Brexit deal. Alternatively, the new administration could seek opposition support. Ultimately, this might soften Brexit but it would be a difficult balancing act, and the risk of a mishap, leading to ‘no deal’, is material."

Di Lizia said another key dynamic will be the outlook for May as Prime Minister, with the potential for a leadership challenge depending on reactions within the party.

Such a content would further increase political uncertainty given the Brexit negotiations are due to begin later this month and will continue to see yields and the pound dragged about like a rag doll.