Is the Market more Confident of BOE Rate Hike than Fed Move?

Bank of England

The UK has reported its highest rise in weekly earnings in four years, causing many to question whether the Bank of England may raise rates earlier than previously anticipated.

A week ago the UK reported a larger than expected rise in average weekly earnings for the three months through April.  The 2.7% rise is the highest in four years.

It followed a revised 2.3% increase in March, which had originally been reported at 1.9%.  Recall that last June average weekly earnings had actually fallen by 0.2% on a three-month year-over-year basis.

More than any other economic development, the increase in UK wages has spurred ideas that the Bank of England may raise rates earlier than many previously anticipated.  Comments for three BOE members (Cunliffe, Forbes and Weale) over the past week or so have shown the hawks may be on the ascendancy.

Weale’s comments were quite pointed, suggesting he is inclined to support a rate hike as early as August.  Weale tilts toward the hawkish side, and this would not be the first time he was out in front of the MPC.  Since joining the MPC in 2010, he has dissented around a dozen times, only to retreat.

What is different this time is that the UK economy continues to absorb slack and the labor market is approaching what economists generally regard as full employment.  There are a number of economists that have begun talking about the first BOE hike in the middle of Q4.  The implied yield of the December short-sterling futures contract has risen 11 bp over the past couple of weeks.  It now implies a 3-month yield of 78 bp, which is about 21 bp higher than 3-month LIBOR and 28 bp above the bank rate.

By way of contrast, the December Eurodollar futures contract implies a 57 bp yield, which is only a few of basis points above the year’s low set in mid-May, near 53.5 bp.  The Fed funds band is 0-25 bp.  Three different Fed officials spoke of the potential for two hikes this year, which is where the median dot-plot remained at the FOMC meeting earlier this week.

Capture

This chart from Bloomberg shows the implied yield of the December short-sterling (white line) and Eurodollar futures (yellow line).  The factors driving this divergence appear to be underpinning sterling.  Sterling rose to new highs for the year the day after the UK employment/earnings data was released (~$1.5930).  It has drifted lower in recent days, but held a 38.2% retracement of the leg up that began on June 8 near $1.5220.  That retracement comes in near $1.5660.

The Fed funds futures settled not at the policy rate, but the effective average rate.  This is an average, weighted by volume.  The effective Fed funds rate has been averaging the middle of the current target range or 12-13 bp.   The general assumption is that the Fed funds rate will gravitate around the middle of the new target range.  That means that fair value for the November contract, assuming a rate hike in September (or theoretically in October), would be 37.5 bp.  The implied yield is currently 26 bp.  This seems to imply a 50% chance of a 25 bp hike.   

The Fed draws a distinction between inflation expectations derived from market pricing and from surveys.  It has shown a preference for surveys.  Surveys, like the Wall Street Journal’s, suggest almost 3/4 of the respondents expect a September hike.  We think expect the Federal Reserve to hike rates at least once, but probably twice before the Bank of England raise rates.

The rise of sterling on a broad trade-weighted basis of around 7.5% this year imparts a tightening impulse.  Feed through from the trade-weighted developments to the UK economy is faster and more significant for the UK than the US.  In addition, because US home owners mostly have fix rate mortgages, Americans are less exposed to a rate hike than UK homeowners, where the variable rate mortgages adjust quickly.