Financial conditions in the UK remain accommodative, signaling confidence that the policies of the monetary and fiscal authorities have created the framework for a sustained economic recovery.
The RSM UK index suggests less risk being priced into financial assets.
Ahead of the Bank of England’s critical decisions on policy normalization on Thursday, this should provide the central bank with plenty of room for consideration of conditions in the real economy as it makes its final decision.
Our composite RSM UK Financial Conditions Index remains at 1.1 standard deviations above normal levels, suggesting less risk being priced into financial assets.
Because of this reduced risk, the costs for day-to-day business activity as well as long-term investing are lower, facilitating economic growth in the coming quarters.
The UK markets have begun to anticipate the start of the long process of interest rate normalization. The forward market—a thin and illiquid market—is pricing in a 63% chance of a Bank of England rate hike at this Thursday’s meeting and a total of four hikes over the course of the next 12 months.
But at 63% probability, this is still a close call. We expect the vote to be 5 to 4 in favor of leaving interest rates at 0.1%. This might imply a glass half-empty, glass half-full policy of keeping the central bank’s rate at near zero for another Monetary Policy Committee meeting or two, with forward guidance preparing the markets for a rate hike in December or early next year.
Because of the upward pressure on money market rates caused by policy concerns—plus the threats of near-term price increases and long-term wage increases—the degree of accommodation built into UK financial asset markets has drifted ever so slightly lower in recent trading.
Money market spreads widened a bit, while the yield-curve spread between 10-year government bonds and 3-month T-bills flattened, reflecting concerns for long-term growth if the Bank of England were to lightly touch the brakes.
Indeed, whatever the outcome of the vote on Thursday, the bank will probably push back against the degree of tightening assumed by financial markets.
It could do this by saying that if it raised interest rates in line with what financial markets have priced in, then inflation in two years would be below the bank’s 2% target. That might cause interest rate expectations and gilt yields to give up some of their recent gains.
All in all, the markets are continuing to price in a high level of monetary policy accommodation.