The Bank of England is likely to wait until the first Budget after the next General Election (due before June 2010) before seriously contemplating raising the Base Rate from its current level of 0.5%.

There is an outside chance Gordon Brown will call an election this autumn but it is far more likely to take place in May 2010.  The MPC will want to wait and see if taxes are raised in the new Government’s first Budget which will surely follow shortly after the General Election, otherwise the BoE runs the risk of raising rates before an election only to have to lower them again shortly afterwards to offset fiscal tightening by an incoming Government getting to grips with the budget deficit.

There is so much spare capacity be be worked through when the economy recovers that the MPC runs little risk of falling too far behind the curve by waiting until after the next election before starting to take back some rate cuts.  The MPC will surely want the economy to develop some serious momentum before risking tightening monetary policy as they will not wish to snuff out an economic recovery by raising rates too soon (which was the mistake made by the Japanese in 1997).  The MPC can easily afford to wait to see a clear turn lower in the unemployment rate without running the risk of allowing inflation to run away.

So the stage is set for Base Rates to remain at 0.5% until at least the summer of 2010.

The Fed made it clear to the market with this week’s FOMC statement that speculation of a rise in the Fed Funds rate anytime soon is completely misplaced.  The Fed pointed out that with US GDP still contracting the economy has not yet even begun to work through the vast amount of slack in the system (capacity utilisation down near 65% and unemployment at 9.4%). It is this same spare capacity that means they are also not worried about the recent rise in energy & commodity prices feeding through into a sustained rise in inflation.

Even when US GDP starts to grow again (possibly later this year given that excess inventories now seem to have been worked off by manufacturers) it will take many quarters to chew through all the slack in the system (and the US economy has yet to contend with Obama raising taxes/allowing the Bush tax cuts to expire).  Therefore the FOMC “continues to anticipate that [the Fed Funds rate will stay at 0.25%] for an extended period”.

Those who think that the economy will bounce back strongly and that the Fed will soon be taking back some of its rate cuts should watch what the Fed does when it completes its $300 bln purchase of Treasuries in the autumn.  If the Fed announces it is going to spend additional money buying Treasuries then rate hikes will stay off the agenda.  Stock markets have bounced and bond yields have backed up as financial markets have regained their poise this year after the carnage inspired by Lehman’s bankruptcy last autumn.  Markets have gone from pricing in a depression to pricing in a prolonged recession and equities are currently consolidating after their sharp rally off the March 2009 lows and digesting the supply of fresh equity from corporates who are either getting their balance sheets back into shape or raising funds to take advantage of opportunities they see in the current environment (banks are not lending and credit spreads remain wide so equity is currently the default source of funding).  This is why the “green-shoot spotters” are out in force at the moment as the next move in the markets will be driven by perceptions of economic recovery or a slip back into a W-shaped recession.

For the foreseeable future the Fed continues to stimulate the economy by keeping rates close to zero and buying up Treasuries & mortgage-backed securities.  It will keep the pedal pressed firmly to the metal until the economy has grown sufficiently to have taken some of the slack out of the system.  Anyone expecting the Fed to hike rates the instant GDP starts to grow again is going to be disappointed (it is not going to repeat the 1997 Japanese mistake of raising taxes and snuffing out economic recovery the instant it has started)- a better guide to the timing of a rise in the Fed Funds rate will be given when the unemployment rate is at least two percentage points off its high and capacity utilisation is above 75% and the Fed has seen what impact any Obama tax increases have on the economy.

Notwithstanding the Bank of England doing its best to inject £125 bln into the Gilts market, Gilt yields are backing up along with US Treasury yields and those of German Bunds.

There are basically two schools of thought as to why gilt yields are rising.  The more popular at the moment is that government bond investors are running scared of the deluge of supply of new government debt which is coming the market’s way over the next few years and the yield backup is a way of making room for all this new supply.  The other (less popular) explanation is that markets are anticipating economic recovery and the backup in bond yields simply represents the usual move away from risk-free assets to other more risky securities such as equities and corporate debt.

The second explanation is consistent with the rally in equity markets (with cyclicals such as retailers & mining stocks outperforming defensives such as pharmaceuticals, food processors & utilities) since early March and is also given credence by the synchronised backup in US, UK and German government bond yields.  The Dow has also broken above its 8587 May 8/20 double-top this week and is continuing the rally which started in March and which paused for breath during May (we have had two daily closes above 8587 which have negated the double-top reversal pattern).  The rally in the oil price is also consistent with an expectation of economic recovery and the only market not rallying is credit spreads.  Ordinarily these would be expected to tighten in anticipation of an economic recovery but this time it may simply be the case that banks are still not in a position to lend freely and the SIVs (which would normally be borrowing close to Libor and buying corporate bonds at wide credit spreads) are not in business any more.

Markets are clearly rallying in anticipation of economic recovery which means the rally will only be derailed by clear evidence that the economy is not recovering as per market expectations (i.e. we are still bumping along the bottom or we are going to double-dip back into a W-shaped recession); the catch is this evidence may not show up for quite a while…in the meantime it looks very much like the bears are going to be squeezed hard all summer long.