LONDON, Dec 16 (Reuters) - The Bank of England looks like it's being outed as the weakest link.
Sterling's withering slide on Thursday in the thick of this week's central bank tightening spree suggests the BoE is favourite to be the first among Western peers to blink when faced with a deepening economic downturn next year - even if inflation is still above target by then.
Fair assessment or not, that calculation feeds off deep splits within the Bank's monetary policy committee (MPC) and a peculiarly British vulnerability to the unfolding downturn that was revealed in technicolour during September's UK budget farce.
In what first appeared like an impressive show of force this week, the U.S. Federal Reserve, the European Central Bank, Swiss National Bank and Bank of England all raised interest rates by half a percentage point each and all signalled determination to tighten policy further to snuff out inflation.
But while soundings and guidance around the future resolve of the Fed, ECB and SNB were seen as relatively hawkish, it was a different takeaway from the UK central bank.
Revealing doubts, the recently buoyant pound took the heat on the day. Sterling recoiled more than 1% against the euro - in its second worst day since the September collapse and among the worst five days it's seen since the pandemic hit. It also fell 1.5% against the dollar and 1% on the Swiss franc.
The primary reason was that two of the nine-person MPC voted to end the Bank's rate rise campaign right away as the recession the Bank thinks is already underway will get entrenched next year.
Even though a majority of six opted for the half point move and another voted for matching November's jumbo 75 basis point rise, Silvana Tenreyro and Swati Dhingra reckoned nine straight rate rises to date were "more than sufficient" to get inflation back to the 2% target from more than 10% at present.
Tenreyro's stance on peak rates had been well flagged last month - but many had assumed Dhingra would opt for another hike, even if a smaller one than delivered. With two voters now arguing to stop tightening altogether, tension mounts.
What's more, many investors read Catherine Mann's lone uber-hawkish vote for 75bps as another potential signal of an early halt to the campaign.
While Mann felt another sharp shock may have been needed to break 'inflation psychology' embedding in wage settlements and expectations, there was an element of getting it out of the way quickly before deep recession makes that near impossible.
"Pulling forward monetary action now would reduce the risk that Bank Rate would need to rise well into next year even as the economy slowed further," she was cited in BoE meeting minutes as arguing.
THE END IS NIGH?
Candriam fund manager Jamie Niven said that while February and March BoE decisions may yet hinge on wage settlements emerging from a wave of winter labour strikes in the public sector, the bar goes much higher after that.
"It is difficult to foresee the BoE being able to continue hiking in Q2 as the impact of earlier hikes feeds through," he said, adding "risks are still to the downside in terms of terminal pricing".
If the pushback against any further tightening has started in earnest with base rates at 3.5%, it makes market pricing for peak rates of 4.5% seem even more of a stretch - even if that implied 'terminal rate' crept lower to 4.5% on Thursday from about 4.6% before the BoE decision and more than 5% in late October.
On the flipside, the Bank's statement and Governor Andrew Bailey's comments, rather pointedly, did not protest the extent of market pricing the way they had done at last month's meeting.
But with the median economist forecast for the Bank's terminal rate somewhere around 4.25%, markets still seem aggressively positioned for a hawkish surprise and the pound may be more vulnerable to that revision as the winter progresses.
"With two members voting to pause on the hiking cycle, it's clear that the overall appetite for further monetary policy tightening is starting to wane amongst the committee," said Deutsche economist Sanjay Raja, adding there was now a "real risk" to Deutsche's forecast for a 4.5% terminal rate.
Significantly, the implied Fed terminal rate edged higher to 4.9% after its policy setpiece on Wednesday - even if is still below the 5.1% the Fed indicated. The ECB equivalent did likewise toward 3%, while announcing a relatively punchy timeline for its balance sheet unwind.
The chance of a wobble on Threadneedle Street seems higher.
"With an increasingly discordant committee, future hikes at subsequent meetings might not seem as obvious, even if ongoing inflationary pressures should continue to direct the Bank's actions," said Charles Hepworth, Investment Director, GAM Investments.
And if an anti-inflation resolve is in doubt, on top of a heavy UK government bond sale schedule and amid active gilt sales from the BoE's balance sheet, the ghosts of September may not be far off.
"After its recent bullish run, sterling strength could be somewhat more questionable from here," said Edward Hutchings, Head of Rates at Aviva Investors. "And with further Quantitative Tightening to come plus a staggering amount of gilt issuance, 2023 will continue to be volatile for the UK gilt market."
The opinions expressed here are those of the author, a columnist for Reuters.
(Writing by Mike Dolan, Twitter: @reutersMikeD; Editing by Susan Fenton)
