UK CPI data supports ‘hawkish pause’ from BOE

UK inflation data was in line with expectations, at 3.1% for August. This is a rise from 2.9% in July, and is inline with expectations. Of course, the real shock to price growth will be September, when oil prices surged above $100 and the price of unleaded petrol and gas rose to their highest levels for 4 years. 

Relief that price pressure was not worse 

However, there is still a small sigh of relief that price pressure was not worse last month, which would have added to the increasing peak for UK prices. Unsurprisingly, transport prices added the most upward pressures to the CPI index, while core prices remained stable at 2.6%, unchanged from the July figure, and service price inflation also remained at 3.4%. 

Inflation outlook remains problematic 

For now, there are no signs that inflation is passing through to the broader economy. However, there are some details in this report that will upset the hawks at the BOE, including the 6.1% annual increase in raw material costs and the 3.7% increase in factory gate prices. Either these will be passed on to a stretched consumer, or business profit margins will get squeezed. Neither are positive for the UK economy. 

Rate hiking cycle still a possibility 

Core prices remained stable, this is good, however, the BOE has mentioned that energy prices are now key for inflation expectations instead of core prices. The energy price cap is expected to remain high over the winter, and there is growing concern that the price cap could rise by 25% in January if energy prices remain this elevated. 

So, while expectations for a rate hike tomorrow from the Bank of England have been scaled back by the interest rate futures market in the wake of this CPI report, the detail of the August inflation data means that the BOE cannot take future rate hikes off the table. There are still approx. 4 rate hikes priced in by the end of next year. The only way these will be eradicated is if the war in Iran ends, and supply constraints in the Middle East are resolved. Until then, the spectre of a prolonged rate hiking cycle will remain over the UK, darkening the economic outlook. 

BOE’s main job is inflation control

We expect a ‘hawkish hold’ from the BOE on the back of this week’s data. The CPI data and the employment report need to be taken together. The labour market is weakening, and Tuesday’s data was weak across the board, including job vacancies, a decline in payrolled employees, and negative real wage growth for private sector workers. However, energy prices remain a key concern. The BOE’s only job is to control inflation, and with headline CPI expected to peak above 4% later this year, they have to act, even if the economy is looking fragile. 

UK Bonds: It’s all about the Fed

UK Gilt yields have moderated slightly at the very short end of the curve on the back of this inflation reading, and for now the incessant rise in Gilt yields is taking a pause. This pause is also a reflection of the short, sharp shock in the UK Gilt market in the last 2 weeks. In just 5 days UK 2-year Gilt yields are higher by 21bps and the 10-year yield is higher by 11bps. We could see a further moderation in UK Gilt yields this week, especially if the Fed and the BOE push back on the idea of a prolonged rate hiking cycle. 

The market view 

Stocks are rising in Europe, oil and other energy prices are also lower on Wednesday, however, Brent crude remains above $107 per barrel, and the market is in wait and see mode before the Fed rate decision later tonight.

The pound is weaker, reflecting the view that the CPI data was not as bad as feared. Key support for GBP/USD comes in at $1.3450. US equity futures are pointing to a higher open as the semiconductor trade continues with its mild recovery. 

While UK inflation data is important for the UK bond market, in the next 24 hours its all about the Fed. If the Fed fails to hike or sounds less hawkish than the market expects, we doubt this will be good for bonds, and instead will boost gold, as the market frets that the world’s most important central bank will lose control of inflation.