The Bank of England's (BOE) Monetary Policy Committee (MPC) meets Thursday and is expected to keep interest rates unchanged, marking a sharp turnaround from early projections just a few weeks ago.
A month ago, short-term interest rates had been pricing in another 25 basis point rate hike with near certainty (90 percent odds). But Governor Mark Carney lowered expectations after dovish comments he gave in an interview with the BBC, referring to data that was coming in on the "softer side." He added that there "may be some differences of view at the May meeting, but that it is a view we take ... conscious that there are other meetings over the course of the year."
Markets were quick to slash hiking odds in May to 50 percent. Only a week later, the first quarter GDP (gross domestic product) print came in at a tepid 0.1 percent quarter on quarter, below consensus of 0.4 percent and the BOE's own forecast of 0.3 percent. Short-term interest rates are now pricing in less than a 10 percent probability of a hike this Thursday.
Meanwhile, the pound has gone full-circle and is now at weaker levels than where it started the year as investors price out rate hikes and come to terms with a slower growth profile, alongside a strengthening dollar.
While first-quarter GDP data disappointed, analysts at Goldman Sachs point out that only 45 percent of preliminary estimates are based on observed data, with the rest being modelled. This explains why preliminary estimates tend to be revised and this print is no different. They add that the slowdown in retail, a pick-up in electricity and gas and an outright contraction in construction typically mirrors the weakness associated with unseasonably cold weather, supporting the premise that the weak print was hampered by one-offs rather than a more structural slowdown. April PMI (Purchasing Managers' Index) numbers have already started to show a moderate rebound.
Kallum Pickering of Berenberg points out that the drop in construction alone accounted for 0.2 percent of the decline in first-quarter GDP, a disproportionate impact given construction only makes up 6 percent of the country's GDP, while the dominant service sector continued to expand in line with the 2017 average.
The BOE is thus likely to play down the impact of first-quarter numbers even though the weak print will have to be factored into its 2018 growth forecast.
The market will also be looking for further clues from the updated inflation projections in the BOE's inflation report. In February, the MPC had inflation returning to 2.1 percent over its forecast horizon (slightly above a stated target of 2 percent), contingent on a rate hike path that included three hikes cumulatively.
Since February, short-term interest rates are now pricing in fewer hikes over a three-year period. The labor data have remained strong, with latest pay growth numbers rising. Oil prices have, meanwhile, risen 6 percent but the inflationary impact is expected to be offset by the slightly stronger pound since the last snapshot was taken.
Hence, there is a reasonable chance that the medium term target of 2.1 percent stays as it is. This implies that further monetary tightening may be warranted in order to get inflation back to target. The market would be quick to price in any rate hikes that had been priced out since the last report.
If the BOE also plays down the weak GDP data and continues to emphasize the reduction of slack in the economy, we may also see the market bring forward the odds of an August hike (now priced for 60 percent).
One thing is for certain: Investors will want more clarity on the central bank's thinking from here as short-term interest markets have been extremely volatile into the event.