As UK markets digest a fresh set of dovish inflation data,Vasileios Gkionakis, Senior Economist and Strategist at Aviva Investors, argues in the following analysis that growing evidence of softer price and labour market dynamics strengthens the case for a BoE rate cut in December.
“Last week I wrote about the increased likelihood that recent UK economic data meant that the BoE 3Q forecasts would be surprised on the weak side (wage growth, unemployment and activity). This week was a very important one, with the release of September CPI, that was supposed to peak at 4% Y/Y. Turns out there were widespread downside surprises, visible in the headline, the core and services inflation metrics. I will not bore you with the precise details of the releases, but headline inflation came in at 3.8%, 20bps lower than the BoE forecast, whilst Services inflation came in at 4.7%, 30bps below the BoE forecast.
“To be clear: inflation is still running way above target. That said, we knew this at least six months ago, and the bulk of the increase is down to increases in administered/regulated prices and the hike in employer NICs contributions. As such, the pickup in price growth is not being driven by robust demand (an inflationary environment that should concern a central bank) but instead by temporary factors. Second round effects are certainly a worry through inflation expectations; however, the BoE household inflation expectations for the next 12 months have picked up only modestly and are not far away from their 2010-19 average, while market-based measures of inflation expectations have been falling. And the latest news suggests that (1) the labour market is in a worse state than it was assumed and (2) the peak in inflation is likely lower than thought.
“The Gilts market has responded accordingly to the flow of information, with 10Y yields down by more than 30bps since 9 Oct; and now the market pricing for another rate cut by the end of this year has risen to 18bps (i.e. a probability of 72% of a 25bps of easing) while the terminal rate has moved much closer to our expectations (3.25%) at 3.35%.
“The bottom line is this: there has been accumulating evidence that has caused the market to start repricing significantly the trajectory of BoE rates. I think the Bank will cut rates in December as I explained in my previous article, and I still think the risks are for further downside, with the UK Budget now on the horizon. So, rates can still reprice lower (and the long end can price out some of the risk premia) while GBP is likely to underperform. EURGBP is up 5% this year but I still think it is poised for further upside.”
