UK Interest rates: an update

Where next for UK interest rates? The ongoing message from the Bank of England can best be summed up as: interest rates will stay low, rise gradually and peak at a lower level than previous cycles. Although these have not been the exact words used, that has been the underlying reassuring implication for the markets. In the wake of the recent Inflation Report, there is, however, a greater degree of uncertainty, because of the forthcoming EU Referendum,  mixed data and increased doubts about the state of the economy. 

Growth is only modest and lacks momentum. At the beginning of last year, conflicting data was then attributed to uncertainty ahead of the May 2015 General Election. Likewise now, with the Referendum. While both may be true, it highlights the difficulty of determining underlying economic trends around such big event risks. 

Any monetary policy response to the Referendum is likely to be a reassuring one. The Bank has already made clear it will ensure sufficient liquidity ahead of the day and, if there is a Brexit vote would then be expected to provide enough liquidity and reassurance to stabilise conditions. If there was a vote for Brexit, I would not expect policy rates to rise and, indeed, would not be surprised if they fell.

Much will depend upon how markets had behaved ahead of June 23rd, - and thus what is discounted - and of course on the result itself. If ahead of the Referendum sterling is weak, then general market thinking will be that a vote for Remain will provide a boost to sterling and risk assets. 

Although overall policy on interest rates would not change, there would likely be some firming up of interest rate expectations. The trouble is, even with a Remain vote, the economy is likely to continue to slow. House prices, too, may ease. Policy rates would, in our view, be expected to remain unchanged in the immediate future even with a remain vote.

The greater challenge is that the economy is at the stage of the economic cycle where it may be starting to slow down. This may come as a shock, as for many people the general feeling among the public is that the recovery has not yet been strong enough, while in the markets the discussion is generally about exit strategies, key to which is when the first interest rate hike will take place.

Perhaps the UK should learn from the US, where the economy did not react well to the rate hike last December. Indeed, the reaction in recent days to the relatively hawkish tone of the Federal Open Market Committee's (FOMC) April minutes again illustrated the market's sensitivity to any prospect of a US rate hike. Currently the US markets are discounting a 30% probability of a quarter point hike in June. It still seems more likely that rates will be left on hold then.

The lesson for investors and for the markets is that the Bank of England is unlikely to hike rates prematurely and should wait. But, if Brexit occurs, then both rates and sterling could fall. And that may be just what the economy needs!

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