Schroders: As UK growth rebounds, are rate rises on the horizon?

The preliminary estimate for GDP showed the UK economy rebounded in the second quarter, following a disappointing start to the year. Real GDP growth picked up to 0.7% in the three months to June, an improvement compared to the 0.4% growth recorded for the previous quarter. On a year-on-year basis, growth slowed from 2.9% in the first quarter to 2.6% in the second.

The pickup in activity was driven by an improvement in industrial production, where growth in the mining and quarrying industry picked up sharply to 7.8% quarter-on-quarter, compared to -0.5% previously. Manufacturing, which is a sub-sector of industrial production, contracted over the quarter (-0.3%), highlighting the difficulties manufacturers face as the strength of sterling hits export demand. The services sectors also improved, growing by 0.7% compared to 0.4% previously, with business services and finance showing the greatest improvement (0.8%, up from 0.1%). Otherwise, construction activity was flat during the period.

Overall, the latest GDP figures suggest that the economy is performing strongly and should continue to create more jobs, putting upward pressure on wages. We forecast the pace of growth to remain similar until the turn of the year, before austerity starts to slow activity.

As for the Bank of England (BoE), with external concerns such as Greece subsiding, the Monetary Policy Committee (MPC) will be seriously considering whether it is time to start raising interest rates.  We expect the Bank to hold fire until early next year, as the current annual rate of the Consumer Price Index (CPI) inflation is zero. This is significant as the BoE’s inflation target is set as a 1% upper and lower band around a 2% central target.  We do not think the MPC will want to explain to the public why it needs to raise interest rates, but at the same time, the Governor is writing letters to the Chancellor to explain why inflation is too low. It would be a communication nightmare.  We forecast CPI inflation to rise above 1% at the start of 2016, which should give the MPC cover to start hiking.

Once the BoE starts to hike rates, we expect it to tighten at a faster pace than markets are currently pricing, which should put more upward pressure on sterling. Further rises in the pound are likely to have a negative impact on UK equities, especially for companies that have a high reliance on overseas earnings. Of course, for gilt investors, higher-than-expected interest rates should cause gilts yields to rise and prices to fall.