Peter Schaffrik: Welcome back to European Markets. Today is the 22nd of October, 2024, and my name is Peter Schaffrik. Today I'm going to be joined by Cathal Kennedy, RBC's senior UK economist. Today, I'd like to talk about three things. First, about the ECB and the recent speeding up of interest rate cuts; secondly, about the Bank of England; and thirdly, about the UK budget. And thankfully, Cathal is here to enlighten us. The ECB has increased the speed at which they cut interest rates. They cut again in October, which about a month ago, was not expected. They justified this by, A, weaker growth, and more importantly, weaker inflation. Interestingly, the market is now starting to price a certain probability that they will speed things up further, including the probability that they might even go 50 basis points in December. The chart that you're currently looking at shows that this is the case for the next three meetings, where a certain probability of a larger interest rate cut is implied. Ultimately, we think that's probably going to be a step too far. We think they will continue with 25 basis point increments and they will end up at 2.25, which is slightly less than what the market is pricing. However, 50 basis point steps for us seem unlikely. In contrast, when you look at the next chart, the market is pricing less than we expect, as far as the Bank of England is concerned, which by itself, looks a bit as an opportunity. In order to better understand it, let's bring in Cathal. Cathal, why does the market not price a bit more aggressive Bank of England cuts?
Cathal Kennedy: I think the first thing to know, Peter, is that the economic backdrop in the UK looks relatively healthy at the moment, certainly in contrast to the Euro area. Now, despite that to some extent, we just recently revised our own Bank of England call. Now we see them delivering successive 25 basis point cuts between the November and May meetings next year to take bank rate to 3.75%. Now, some of that just simply reflects the changed rhetoric from the bank. The governor, Andrew Bailey, who was previously fairly cautious in terms of what he was saying, said in a recent interview that the MPC could be a bit more aggressive in respect to reducing rates if inflation pressure eased. We think there's accumulating evidence that that is the case in the UK. First off, we're seeing pay growth normalise, if you will, and a pretty broad-based slowing in the growth of pay. Secondly, services inflation, focus for the MPC, is below 5%. Considerably below where the bank saw it as recently as its August forecast round. I think there's accumulating evidence that inflationary pressures are easing in the UK. I will go back to the bank's scenarios or cases that they have laid out in terms of the future path of inflation and monetary policy. The first of those sees domestic inflationary pressures ease as the external shocks that caused the ease. The second one is where policy needs to be a bit more restrictive to basically squeeze those inflationary pressures out. The third one is a “tighter for longer” scenario due to structural shifts in the economy. Now, we think, reflecting the rhetoric of the governor, that the majority of the MPC is in that first scenario or comfortable with that first scenario.
Peter: That's very clear. For me, that makes sense, and that's already an argument in my mind to prefer UK fixed income assets over the Euro area at the moment. If you look at the chart, we're still trading relatively wide in the spread terms. It's not only because of the Bank of England because when we speak to our investors, it's also clear that the forthcoming budget in the UK is putting quite a bit of fear in some investors that spending might increase quite significantly. Cathal, can you fill us in a bit? What is the fear that you're hearing when you speak to people?
Cathal: Well Peter, we have a new government in the UK in place since July. In the run-up to this budget, they've made two things clear, if you will. One is there's to be no return to austerity, and the second is that they want to borrow to invest more in the UK.
Peter: That's clear, but can you give us a bit more meat to the bone? What concretely is it? What are the numbers that we're talking about that people are fearing?
Cathal: To take the first one, the government inherited a tight spending plan, which if stuck, if adhered to, would have meant them delivering cuts to some areas of spending in the run to the next election. The first thing they want to do is basically to avoid having to make those cuts. To do so, they've promised an increase in taxation coupled with savings in some areas of the budget, most notably welfare. Essentially they're doing that because they have promised to only borrow to invest over the cycle, if you will. Now, where the market got a little bit concerned was in perhaps switching the fiscal rules to open up more space to borrow to invest. At the moment, the UK's fiscal rule is measured against public sector net debt, excluding the Bank of England. If you look at the chart here, that's the navy bar on the left-hand side. Now, for some time, we've discussed a tweak to those rules, which would move it to public sector net debt, which includes the Bank of England. Essentially, the government benefiting from the rundown of the bank's intervention in the economy over the forecast period. That's fairly small. At the March budget, it would open up around 16 billion of extra borrowing capacity. Now, at the Chancellor's speech to the Labour Party Conference, she spoke about getting the Treasury to take more account of the benefits of investment, as well as the costs of doing it. That created a debate in the UK about moving to a different measure of public sector balance sheet completely. In the chart, public sector net financial liabilities and public sector net worth. In these cases, that would open up a potential, and I stress the word potential, extra 50 billion in borrowing headroom, if you will, for the government. I think it is that aspect, those big numbers, if you will, that perhaps got markets a bit nervous.
Peter: But just to be clear, that's not what you are expecting that’s going to be ultimately adopted?
Cathal: No, we still think it'll be a more minor tweak, if you will, that opens up some space for investment spending, but not some of the big numbers that have been discussed in some places.
Peter: Thank you. That sounds a bit more reassuring. For me, if I look at the market at the moment, as we discussed, the ECB seems to be a bit overpriced relative to the Bank of England, which seems to be a bit underpriced, which opens up an opportunity in the first place. Secondly, there's probably a worry in the market that spending could increase substantially in the UK, and therefore, borrowing as well, which ultimately we think is probably a bit unfounded. Therefore, we think the UK looks probably quite attractive relative to Europe. With that, we shall close for the day. Thank you, Cathal, for joining us, and I hope you're going to join us again next time.