Despite a fairly positive labour market, the Bank of England (BoE) indicated it was likely to scale back the number of base rate increases to a 0.25% rate hike over the next two years.
This decision was justified by the downgraded global and domestic economic outlooks and, of course, the acute uncertainty around Brexit.
Weak global growth
Brexit aside, the weaker than expected growth observed in the global economy, and particularly in Europe where growth dropped to just 0.2% in the final quarter of 2018, may well weigh on the UK.
Global growth has continued to slow down over recent months and the MPC is now expecting a sharper and more persistent slowdown than previously anticipated.
The UK’s GDP growth has also shown signs of weaknesses in early 2019 and the BoE has warned that the economy is on course for its weakest year since the global financial crisis.
January’s Purchasing Manager Index (PMI) readings were weaker than usual and house prices cooled again last month.
This news sent Sterling to a two-week low of around $1.29 USD ahead of the MPC meeting on 7 February.
Deal or no deal?
The BoE stressed that the performance of the economy would be highly dependent on how Brexit unfolds.
The economic impact of Brexit concerns is already being observed as UK businesses set up contingency plans and hold back on investments, which fell by 1.1% in Q3 of 2018.
The BoE also emphasised that these concerns were now spreading to UK households, leading to the softening of consumer confidence.
As a result of this, the BoE cut its near-term UK growth forecasts from 1.7% to 1.2% this year and from 1.7% to 1.5% in 2020 – meaning an increased chance of the UK sliding into recession this year.
However, it does expect activity to pick up towards the end of the year but the higher short-term volatility makes it unable to raise rates for now.
If an orderly Brexit does take place in the coming months, this could see the BoE restart its original plan of gradual but limited interest rises.
A no-deal Brexit, however, would likely see Sterling fall, causing a spike in inflation.
In such a scenario the BoE is not expected to rely solely on rate cuts and may well consider other monetary financing tools.
In light of these considerations, the markets forecast the BoE base rate to hold at 0.75% for at least the next two years, before rising to 1%.
The base rate will then remain at 1%, for the next year after that.
Similarly, the three-month LIBOR (London Inter-bank Offered Rate) is now expected to remain steady at around 1%, before rising after two years to 1.25%.
In the swap markets, the current market prediction is that two-year rates will stay at 1% for the next two years, rising to 1.25% after that.
Meanwhile, five-year swap rates are expected to remain at 1.25%, only rising to 1.5% after three years.
There looks set to be little change when it comes to 10-year swap rates: the rates are expected to stay at 1.25% for at least the next three years.