COLUMN-Sterling may decide if BoE can talk markets off a cliff : Mike Dolan

By Mike Dolan

LONDON, Oct 21 (Reuters) – The Bank of England has the inevitable task of convincing the markets they are wrong about how high UK interest rates need to go without giving sterling back its bottom pull away from under your feet.

In all the chaos of UK government decision-making and political leadership over the past month, the BoE has been sidelined and then taken up with a mop to clean up the mess.

In view of the rubble, it is good to at least partially remove the shattered financial market confidence and restore some semblance of credibility to politics.

Two-week intervention to stem the shockwaves hitting UK government bonds and stricken pension funds – all clearly triggered by the unfunded tax-cutting “mini-budget” of September 23 – has helped markets stabilize on their own since Monday.

10- and 30-year gilt yields, which serve as the benchmark for the country’s long-term borrowing, have given back about half and two-thirds of their respective jumps from just before September 23 – albeit at a significant cost of tens of billions additional BoE bond purchases that it will now have to somehow sell back to the market in the coming months.

The additional risk premium of conventional 10-year British bonds compared to German and US equivalents is still around a quarter to half a percentage point compared to the previous month.

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But even after the changing government rolled back most of its controversial budget plans and Prime Minister Liz Truss resigned on Thursday, the BoE is still panicking about how much it will need to raise interest rates to overcome inflation expectations heightened by the crisis defuse .

BoE Deputy Governor Ben Broadbent kicked off the process on Thursday by telling markets that meeting their expectations in a flagging economy could be overkill.

“Whether official interest rates will have to rise by as much as is currently being priced into financial markets remains to be seen,” he said. “If the policy rate really did hit 5.25%, given appropriate policy multipliers, the cumulative impact of the entire growth cycle on GDP would be just under 5% – of which only about a quarter has already come through.”

In fact, futures markets have cut expected hikes to 75 basis points at the Nov. 3 BoE meeting from well over 100 basis points at the height of the shock.

But Broadbent’s focus on likely top-end yields next year is key.

For comparison, the UK final interest rate, now projected for around mid-2023, has risen by almost two full percentage points from just before the botched mini-budget to as high as 6.25%. It was down half that move to 5.25% just prior to Broadbent’s speech – and has since tailed off a little further.

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But at 5.15%, markets are still expecting UK interest rates to rise nearly four percentage points over the next six sessions from the current 2.25% – an average of 65 basis points per session through June. And that’s going to hurt as hard as Broadbent outlined as adjustable-rate mortgage rates and federal interest costs spiral up in tandem.

TERMINAL CROSSING

If the BoE manages to talk this peak back down towards 5% or below, then it will most likely match the corresponding final Fed rate coming from the other direction. The Fed’s terminal rates, now targeted for March next year, have risen 150 basis points to 5% over the past two months.

A crossover of the two peaks would bring an expected short-term spread in favor of the dollar for the first time since August, at levels eight months earlier.

And Morgan Stanley, for example, sees the UK terminal interest rate at just 4% — a huge drop from current market prices.

The big question for the bank is whether concerns about the overall credibility of economic policies and inflation expectations will dissipate enough to lead markets back down without disruption – or whether investors simply assume that the BoE is not ready or in will be able to tighten enough to contain inflation when a deep recession hits.

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If the latter, the pound will plummet again, exaggerating the inflation picture to boot.

The stubborn refusal of terminal yield pricing to return to where it was last month reflects the extent of this nervousness.

“UK inflation appears to be stuck and systemic risk makes it very uncertain for the central bank to fight it efficiently,” said Florian Ielpo, head of macro at Lombard Odier Investment Managers. “With limited tools and burdens, the BoE is in a difficult position.”

Jeffries doubts the change in prime minister and cabinet will solve anything in the short term. “A new government will only inherit the problems that plague the economy and will continue to plague the pound.”

And Christ Turner and his team at ING believe the persistent risk premium still inherent in gilts and other UK assets will be difficult to shake. “The old adage applies here that it takes years to build trust, but only a day to break it.”

The opinions expressed here are those of the author, a columnist for Reuters.

(by Mike Dolan, Twitter: @reutersMikeD. Reporting by Nell Mackenzie; Editing by John Stonestreet)

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