Will the BOE follow the Fed?

Will the BOE follow the Fed?

The FOMC meeting did not disappoint the market bulls. The Dot Plot was considered by some to be the main event at this meeting. The Fed did not change their view that they expect 3 rate cuts this year and this was enough to set off an ‘everything rally’ late on Wednesday that has driven the S&P 500 above 5,200, the Dow Jones has reached a record high, and the dollar index has turned lower. The question now is, will the BOE follow the Fed, or will elevated service sector inflation mean they take a more cautious path?

US rates revised higher in the longer term

There is a euphoric tone in markets on Thursday, as investors wake to a sea of green across US and European stock markets. Futures markets are pricing in an extension of Wednesday’s rally, and at the time of writing the S&P 500 is expected to open above 5,300. If this happens then there could be a scramble for analysts to revise higher expectations for US stock markets this year, which may add to positive risk sentiment. US Treasury yields fell across the curve after the Fed meeting, even though the key development in the Dot Plot was for next year and beyond. The Dot Plot saw rate cuts that had been penciled in for 2025 and another for 2026 get removed. The FOMC now expects rates in 2025 to be close to 3.9%, this is higher than the 3.6% expected in December. Added to this, in December, more FOMC members had anticipated 4 rate cuts this year, now the majority of FOMC members have converged upon 3 rate cuts.

The FOMC also revised higher the R- star, or the neutral interest rate for the US economy. The median expectation for longer term rates was revised up a touch to 2.6% from 2.5% in December.

This is a fairly small adjustment to the neutral rate, and it is below the market’s expectations for long-term rates. Ahead of this meeting, there had been some concern that the neutral rate would have to be revised sharply higher. Now that fear has been pushed aside, the market rally can continue.

The rally in the S&P 500 was broad based and was led by consumer discretionary stocks, financials and communication services, followed by tech. An upward growth revision followed by growing expectations of a rate cut in a few months, is like rocket fuel for cyclical stocks. There is now a 71% chance of a June rate hike from the Fed, according to the CME Fedwatch tool, this is up from a 55% chance on Tuesday.

Will Andrew Bailey drop the cautious tone?

So how could the Fed meeting influence the Bank of England later today? Like the Fed, the BOE is also not expected to change interest rates. The BOE is independent, so they don’t follow the Fed in any way, although monetary policy in Europe and the US tends to follow the same cycle. There has been one difference between BOE Governor Bailey and his counterparts in the US and Europe, Bailey has been more cautious than Jerome Powell and Christine Lagarde when it comes to talking about lowering interest rate rates. This could change today, after a large decline in inflation and a drop in wages.

BOE: watch the vote split

Although price levels are higher than the BOE’s target rate, Bailey may finally feel able to err on the dovish side now that a deceleration in inflation seems to be entrenched. There is a diverse range of opinions at the MPC. At the February meeting, one member voted for a rate cut, 6 for rates to remain on hold, and two members voted for a rate hike. The rate split this month is key to watch. Could the recent deceleration in inflation be enough to cause either one or two of the members who voted for a rate hike to switch to voting for rates to remain on hold? Catherine Mann is a noted hawk, and she has talked tough about inflation in recent speeches. She will be harder to persuade, as she has sounded alarm bells about service price inflation. At 6.1%, this is likely too high for Catherine Mann. However, if she does change her mind at this meeting and votes for rates to remain on hold, this could be seen as a dovish move, and one that firmly opens the door for rate cuts in the summer.

GBP outlook

The market impact of a ‘dovish’ tone to today’s BOE meeting could be felt mostly in sterling and the Gilt market. Sterling is the best performing currency in the G10 this year, and it has maintained its strength for March, with only the Aussie dollar performing better. Ahead of the BOE meeting, GBP/USD is giving back some earlier gains and is back below 1.28.  Losses could be extended if the BOE is considered dovish, the low of the week so far is 1.2668, and is a support level to watch in the short term.

Why the defensive FTSE 100 may continue to underperform

Gilt yields are falling in line with US Treasury yields on Thursday morning, and 2-year Gilt yields are at their lowest level since mid-January. Thus, it may need an explicit dovish shift from the BOE to weigh further on yields and extend the recent rally in Gilt prices. European stocks have opened higher on Thursday, as they benefit from the ‘everything rally’ triggered by the Fed. However, the outlook for the FTSE 100 is less clear, and we think that it may still continue to underperform US and European stocks. The FTSE 100 has defensive qualities, so it may not benefit as much as elsewhere if central banks give the global economy a cyclical boost.

Gold given a boost

Gold is also worth watching today. It rose to a fresh record high on Wednesday, after the Fed meeting. The gold price is now above $2200 per ounce. We have mentioned that gold is an inflation hedge, and it could rally alongside stocks, as it acts as a safety net in case we see inflation reaccelerate later this year.