The Bank of England bites the bullet, but what next?
The Bank of England blind-sided some analysts on Thursday by being the first major central bank to tighten interest rates post pandemic. The UK’s central bank raised interest rates by 0.15% to 0.25%, lifting rates from a record low of 0.1%. The market had expected the bank to take a more cautious approach, especially as the UK has recorded a record high number of Covid infections in the last two days. However, the BOE justified today’s move by saying that the labour market has tightened considerably and was even able to withstand the end of the furlough scheme. While the Bank did sound concerned about the impact of the Omicron variant, it said that it was unclear at this stage how Omicron would impact medium-term inflation pressures. The BOE’s message was clear: its job is to meet its inflation target, and with inflation expected to peak at an upwardly revised 6% in the Spring, that must be the Bank’s focus, even if the economic outlook was revised lower. The hawkish impulse was also felt at the Federal Reserve, who are now expected to raise interest rates three times next year. The question now is, why are US and UK stocks moving higher and where will they go next?
BOE move is good news for banks
Interestingly, even though the Bank of England raised interest rates, UK GDP was revised lower for this year and UK flash service sector PMI for December fell to 53.2 from 57, the lowest level since April, the pound and the FTSE 100 rose in unison. While the BOE highlighted the risks around the Omicron variant, Thursday’s rate rise is a signal from the Bank that it believes that the UK economy is more resilient to Covid and its variants than it was at the start of the pandemic, which is a positive for UK stocks. Interestingly, even the FTSE 250, which is more domestically focussed than the FTSE 100, is higher today and is up 1.3% at the time of writing. The biggest gainers in the FTSE 100 on Thursday included banking stocks: Barclays, Lloyds and HSBC, along with Ocado, Royal Mail and Dark Trace, all companies that should do well during the peak of the Omicron variant. In contrast, the biggest decliners included utilities and some retail stocks a sign that risk appetite was strong as we move to the end of the week. We believe that, notwithstanding the BOE’s downward revision to GDP for this year, the BOE’s rate rise is still a vote of confidence in the UK economy, and we expect that corporate earnings will remain strong, even if they fall from the highs recorded in 2021. Ultimately, corporate earnings drive stock market performance, and if interest rates are being lifted from record lows, then this should be good news for UK and US banking stocks in the long term.
Uncertainty over rates remains high
The BOE said that a “modest tightening” of monetary policy over the forecast period would be necessary for inflation to fall back to the BOE’s target rate of 2%. The market now expects UK interest rates to rise to 1.1% by the end of 2022. There is also more than 60% chance of a rate hike when the BOE next meets on 3rd February, however, we believe that whether or not the BOE does raise rates at its next meeting will depend on the extent of the measures put in place to limit the spread of the Omicron variant. This will also be dependent on the speed and effectiveness of the UK’s Covid booster shot programme and whether or not the government can reach its target to give every adult a 3rd dose of the vaccine by the end of this year. If the UK does go into another lockdown, this could make the BOE’s job much harder as lockdowns play havoc with inflation rates. For example, after the UK had a circuit breaker lockdown in November 2020, inflation actually fell by 0.1% that month. This is why we think that there remains a fairly high degree of uncertainty about the pace of UK rates for next year.
The GBP outlook
While GBP has surged on the BOE rate rise news, we think that GBP/USD has limited upside and could be thwarted around $1.34 in the short term. We prefer short EUR/GBP as the ECB is expected to be a laggard compared to the BOE and the Fed when it comes to raising interest rates. EUR/GBP was volatile in Thursday’s session, although it ended the day roughly 0.3% lower. After breaking below its 200-day sma last week, the technical picture continues to look weak for this pair. Even if downside is limited in the long term, because of how far EUR/GBP has already fallen, we believe that 0.8380, the YTD low, could be in sight, if the pound can maintain upward momentum until the end of the year.
The Fed knocks tech and mega growth stocks
Us stocks were mixed on Thursday after a strong performance on Wednesday after the Federal Reserve meeting. The Fed also made a widely signalled hawkish pivot at this meeting, and there was the largest hawkish shift in dot plot interest rate expectations on record. The Fed is now expected to raise interest rates three times next year, some analysts now expect the Fed to raise slightly earlier, albeit at a more moderate pace, with analysts at Bank of America expecting rate hikes in the next eight quarters. This may not be as hawkish as feared, which is good news for the S&P 500, especially the companies that have a good track record of making profits and companies that are aligned with the economic cycle, as it suggests that the Fed means business when it comes to fighting inflation, yet it is also trying to be sympathetic to the trajectory of economic growth. This is why Tesla has struggled, along with some of the other mega growth stocks in the tech sector. After surging on Wednesday, Tesla’s stock price fell 4% on Thursday, more than the broader tech market. Likewise, Zoom was more than 2.5% lower on Thursday and Door Dash was more than 6% lower. Thus, we are moving into unchartered territory and US stocks are unlikely to react to Omicron as they have to other waves of this pandemic. We are still very wary of tech and prefer the big names like Apple and Alphabet over mega-growth names like Tesla and DoorDash. In the chart below, you will see how the S&P 500 has been outperforming the Nasdaq 100 over the past month, and we expect this trend to continue in the near term.