If BOE Doesn't Know Where It's Going, Any Star Will Do

(Bloomberg) -- A guiding star is now visible over Threadneedle Street with the long-run (R*) Bank of England destination for its key interest rate in a range between 2 and 3 percent in nominal terms, but the dark side of Brexit eclipses official estimates.

• One-month forward Sonia curve is priced for Bank Rate of ~1.21% at the 3Y forecast horizon and maximum of ~1.53% longer term, which reflects the Brexit risk premia and likely below where the MPC would prefer
• New framework for the equilibrium real interest rate was introduced (aka natural rate, neutral rate and r*) which corresponds to monetary policy stance that is neither stimulative nor restrictive and is applied over various horizons (r* = medium-term, cyclical and R* = long run, structural)
• Committee argued the estimate of nominal R* has been reduced since 1990 due to aging global population and a fall in trend productivity growth - demographics globally is a force that will keep a lid on rates
• Estimate of r* was not given but what can be said with certainty is that it is much lower than pre-crisis levels and the path to normalization is short; model imprecision and large error bands exist with such estimates (Carney acknowledges it is as obscure as Brexit)
• BOE is in a dilemma with the uncertain structural change to U.K. economy given the greater variance of potential Brexit outcomes and increased political rhetoric of no-deal exit (Carney warned Friday that risks of no-deal Brexit are ‘uncomfortably high'), as well as international trade wars weighing on global r*
• BOE hikes as it “needs to walk — not run — in order to stand still” (i.e. gradual hikes) given officials' view that real interest rate (r = nominal BOE interest rate adjusted for inflation) is becoming increasingly stimulative (r falling below rising r*)
• Front-end rates modestly bull flattened after BOE's unanimous decision to hike; realized front-end volatility is likely to remain low in the near term given the limited-and-gradual policy path as the Brexit clock ticks toward the October EU summit; leaves a neutral bias on gamma due to the associated negative theta carry on outright longs

• NOTE: Tanvir Sandhu is a global interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

To contact the reporter on this story: Tanvir Sandhu in London at tsandhu17@bloomberg.net

To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Keith Jenkins

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