Today’s minutes signified the MPC in ‘wait and see’ mode but with a mildly hawkish tinge of (again) downplaying China risks, re-iterating the strong underlying UK domestic position and nuancing recent initially apparently negative labour market developments. This disappointed some market hopes of an MPC volte face and generated a small GBP bounceback.
There seem likely to be further GBP upside over the coming months if market risk appetite is supported and as UK rate hike expectations seem likely to be moved forward – February or May 2016 seems more likely dates for the first MPC hike than recent market pricing of around August 2016 (around five months later than round BoE ‘super Thursday’). Labour market and inflation data will likely continue to be key. Key points to bear in mind are: (i) the August Inflation Report forecast above-target inflation in 2018, with Carney indicating that an inflation overshoot was likely if market rates didn’t rise (they’ve instead fallen quite sharply); (ii) Carney reiterated at Jackson Hole that rate hike discussions will come into “sharper relief around the turn of this year“; (iii) the argument that moving earlier makes it more likely for MPC to achieve the aim of raising rates only gradually continues to be relevant (although risk management considerations have been given some fresh life by recent market strains); (iv) at least Weale seems likely to have joined McCafferty in voting for a rate hike by end-year. Obviously it’s not completely one-way traffic – MPC will continue to be data dependent and there are lingering concerns about how ‘balanced’ UK growth is – but overall the distribution seems skewed towards earlier rate rises than currently priced in.
And that would normally be bullish GBP. The catch is that market risk appetite will ikely also be important for GBP prospects given that it tends to be a pro-risk currency. And there are a number of cross-currents at work here – most prominently Chinese data an policy responses, the timing of the Fed rate hike and how it’s presented, the extent of ECB dovishness. While it’s possible that the constellation will work out to allow EURGBP downsides over the next few months (and recent levels have appeared stretched) that’s far from a foregone conclusion. This instead suggests considering long GBP long positions against other G10 pro-risk currencies with greater potential for extra central bank activism (NZD, CAD, AUD, SEK) or EM currencies vulnerable because of lowflation dynamics (AxJ) or funding requirements and commodity exposures (ZAR, TRY, BRL, COP, CLP). I also disagree with GBP bears citing the UK’s large current account deficit per se as a significant downside risk, but it could interact with the Brexit worries which coudl develop over the coming months (most likely when the nitty-gritty of the negotiations becomes more public).
Direct China links not that important for UK
Today’s relatively sanguine MPC take on the Chinese situation – “Global developments do not as yet appear sufficient to alter materially the central outlook described in the August Report, but the greater downside risks to the global environment merit close monitoring” – echoes the message in Carney’s Jackson Hole speech “events do not yet, to my mind, merit changing the MPC’s strategy for returning inflation to target”. An important underlying reason is that the UK’s trade links with China are at the lower end of those within the G10 (see chart below, my August blog detailed the substantially-higher exposures of a range of EM countries). The UK’s lower share of China-sourced imports translates into less exposure to China producer price deflation while the lower share of UK exports means less GDP impact from weaker China demand.
Carney alluded to these weak direct links in his Jackson Hole speech. But markets seem, given some recent weaker UK data, to have instead extrapolated BoE behaviour from anticipating delayed Fed hikes with an overlay of ECB moving closer to expanding/extending QE last week (see here for my preview of why ECB needed to turn dovish). The net result has been that BoE rate hike expectations have been pushed back more than Fed rate hikes (by around five months since BoE ‘super Thursday’, see Chart above).
That said, Carney also discussed “profound secular and cyclical disinflationary forces at work in the global economy” with the important point that “for economies like the UK their impact is being reinforced by exchange rate movements”, potentially justifying downplaying the limited China links point (and of course financial market/confidence links are another matter). But it’s important to remember that in the August Inflation Report MPC actually reduced the assumed pass-through of GBP movements to import price (see here). The MPC minutes mention of “considerable uncertainty” about pass-through looks a bit like a sop to ongoing MPC debate and an insurance policy should that judgment have to be revisited.
MPC’s sanguine take on Chinese/EM developments contrasts with their apparently important role in driving last week’s ECB dovishness. That reflect the frailties of the Euro Area recovery and EA inflation breakevens rendering the effective risks larger for the ECB. The UK economy is more able to absorb any China-related weakness as it’s more similar to the US than the EA (or New Zealand!). But in July I discussed how the Euro Area’s exposure to the entire AxJ region is significantly higher than for China alone (and how tight regional supply chain with China meant that AxJ countries would likely to affected by Chinese weakness). I also noted here that Germany’s exposure to China was relatively high amongst EA members: Wednesday’s strong German trade data indicates no major impact thus far but last week’s disappointingly negative factory orders suggest that it’s too early to call an all clear.
UK Domestic data: glass half full?
But markets also seem to have been somewhat ‘glass half empty’ about the UK domestic situation. Sure UK industrial production disappointed on Wednesday, but that seems to partly reflect timing issues (early car factory holidays) and even with that UK IP momentum looks broadly in the intternational pack (see Chart). Last week’s PMI declines are concerning, especially the weaker employment components, with the headline output indices not differing much from Euro Area equivalents (see Chart). So there are concerns about the sustainability/balance of the UK recovery, including the potential export hit from GBP’s recent strength. While PMI export orders balances have fallen the CBI measure has been more resilient. And the evidence generally suggests that foreign demand conditions have bigger impacts on exports than FX movements – and Draghi’s strong hints at further ECB action offers the prospect of improving conditions in the UK’s main export market. Moreover, other developments mean that it’s a bit of a jump from the headline PMI releases to then start asking why UK should be even thinking about raising interest rates in the coming months (and BoE staff only marginally cut their Q3 GDP growth forecast to 0.6% from 0.7%).
Specifically, the further rises in UK consumer confidence, with particularly elevated major purchases balances, seem to have received insufficient air time given the importance accorded to them in the August Inflation Report. The contrast with the Euro Area situation remains fairly stark (see chart) consistent with EURGBP downside pressure. Moreover, stable UK inflation expectations means that oil price falls seem to be more likely net beneficial (positive real income impact supporting consumption) than worrying (deanchoring inflation expectations) in the UK than in the EA.That said, it’s notable that UK nominal retail sales growth has been lagging both consumer confidence and real retail sales growth (and the broader quarterly consumption series) raising potential questions about what happens whnn inflation rises back more sustainably down the line.
But markets also seem to have been (overly) keen to call time on the UK’s important positive labour market story based upon headline earnings disappointing and small employment declines and in the past couple of months (see Chart). On the former I prefer to focus on private sector earnings (public sector pay increases are divorced from market conditions) which have been stronger and seem likely to rise further given high job vacancies (see Chart). Carney and Broadbent also downplayed the employment slowdown at the August IR press briefing, arguing that they could represent a sign of strength (a tighening labour market) rather than nascent weakness. That’s supported by survey evidence of rising recruitment difficulties (the Chart below shows the reports from the Bank’s regional Agents) as well as the elevated job vacancies. The MPC minutes chipped in that labour supply of older workers could have been reduced by rising real incomes.
Clearly we’re not yet at the point where labour market developments make MPC action imperative – unit labour costs are currently running at only around 1% (unit wage costs a bit higher). And the minutes argued that the unwinding of the previous bias towards creating low-skilled jobs could see both wages and productivity rise (hence with limited inflation implications) although I’m not holding my breathgiven the well-known difficulties calling the end of the ‘productivity puzzle’. But a final important point from the minutes is the judgement that there were signs of core inflation firming. And the bottom line from the minutes was that “Domestic momentum is being underpinned by robust real income growth, supportive credit conditions and elevated business and consumer confidence.”
Sterling prospects: rebuild of rate hike expectations versus risk environment
What does all this imply for sterling? Overall it seems like a battle between earlier BoE rate hikes again being priced in versus potential downsides from elevated risk aversion given that GBP tends to be a pro-risk currency.
The main point from the above is that markets seem to have pushed out UK rate hike expectations too far into the future – a February or May 2016 MPC rate hike look more likely than current market pricing for an August 2016 move. And the charts below illustrate that relative interest rate expectations seem to have been important (proximate) drivers of GBP movements in 2015. And the second chart illustrates that it’s been UK rate expectations that have been more important than non-UK rates. That’s an important difference from USD, where dovish non-US rate news has been the main driver of USD strength in recent months (see here). So bringing forward BoE rate hike expectations, triggered by ongoing data progress and/or more rate hike votes, would be expected to be GBP bullish.
The other difference from USD is that market positioning in GBP is both relatively light and neutral. Its far less of a crowded consensus trade than long USD positions, increasing its attraction from a portfolio diversification perspective.
The important catch, however, is that sterling tends to be a pro-risk currency: adversely affected by recent risk aversion spikes. The Chart above illustrates that GBP’s beta on SPX (20 day rolling window) shifted significantly more positive around mid-2015, alongside a similar USD move as EUR and JPY betas turned negative. And risk appetite effects seem likely to continue to be important in the FX market, although the future direction is uncertain given that it depends on a number of complicated cross-currents.
The (probably) unintended consequence of ECB QE and negative rates has been to turn EUR into a funding currency – appreciating with risk aversion spikes (cf EURUSD’s rise to 1.17 with escalating China worries) along with more traditional safe havens (JPY, CHF). Last weeks’ strong ECB hints at expanded/extended QE have helped support risk appetite and seem to signify the ECB again drawing a line in the sand around further EUR strength (much as it did in 2014 before eventually moving to QE). So further ECB dovishness would tend to be bearish EURGBP via this risk appetite channel as well as more traditional policy expectation effects.
But the important market known unknown is the impact of Chinese data flow and policy measures on future risk conditions. PBOC easing and hints at fiscal support have calmed nerves somewhat near term. But the situation appears fragile and subject to considerable uncertainty going forward.
And there’s the overarching issue of the timing of Fed rate hikes. I argued here how the China worries and associated financial market volatility had turned the case against a 17 September Fed hike, although I’d put the probability a littlle higher than current market pricing of around 30% – based upon US activity/labour data appearing satisfactory, the Fed wanting to be forward looking and apparently believing that the US Phillips curve remains relevent (I note some doubts here) and being keen to avoid the mistakes of the 2004 rate hike cycle. Such a surprise Fed rate hike would likely hit risk appetite fairly hard (likely arguments that future rate hike would be limited/gradual would likely get drowned out) and hence be GBP bearish near-term unless markets then extrapolated that BoE would also move early and this outweighed the risk aversion effects (possible but not my central case). The Fed clearly signalling that it was holding fire until December (the modal case) would likely significantly boost risk appetite and could provide a window for UK rate hike expectations to rise (helped by a closer MPC vote in November?) and hence is likely the most GBP bullish scanario. Even here, however, investors could extrapolate that BoE actions would also be delayed: much would depend on the Fed’s revised projections, the dot plots and Yellen’s press conference. My suspicion that an Yellen will signal that an October Fed hike being is a live option (allowing recent stresses to calm further but avoiding end-year illiquidity) would fall in-between with probably less net impact on risk appetite meaning that rate expectations would likely be clearer drivers of FX moves. So both GBP and USD could see (limited) near-term downward pressure in this scenario given that rate rise expectations would again likely be pushed out, depending on the strength of the signal on October versus downward revisions to dot plots etc.
So a constellation of events allowing for EURGBP downsides over the next few months (on growing policy divergence and unwinding risk aversion effects) isn’t out of the question but is far from a foregone conclusion, requiring several things to fall into place. This suggests instead considering long GBP long positions against other G10 pro-risk currencies with greater potential for extra central bank activism (NZD, CAD, AUD, SEK) or EM currencies vulnerable because of lowflation dynamics (AxJ), funding requirements or commodity exposures (ZAR, TRY, BRL, COP, CLP). The small weights of such currencies in the GBP TWI would also reduce MPC concerns about elevated GBP levels (see here, where I argue that MPC will likely be pragmatic about GBP upsides reflecting underlying UK relative strength).
Downside GBP risks: worry more about BREXIT than the current account
What are the risks to an bullish GBP view (subject to risk appetite remaining supported)?
I disagree with GBP bears citing the UK’s large current account deficit as a significant downside risk (on its own despite), despite market discussion of current account deficit (surplus) currencies tending to underperform (outperform) in recent months. The UK situation is very different than for vulnerable EMs (facing higher funding costs on their large USD-denominated debt). Indeed, the Chart above illustrates that there has been robust foreign demand for UK government debt in recent months without any rise in gilt yields being required to convince foreign investors to hold the UK debt. No risk premia is being demanded. The MPC minutes repeated the well-known point that the UK current account deficit reflects weaker net investment income driven by EA weakness rather than a collapsing trade position driven by excessive domestic demand.
But GBP could potentially be adversely affected by growing BREXIT worries (extra risk premia, where the UK current account could conceivably become more of an issue). An under-appreciated implication of Jeremy Corbyn’s likely election as labour party leader (result due 12 September) is to question the previous assumption of the opposition party campaigning in favour of continued EU membership in the referendum (date likely to be announced at the Conservative Party conference in October) although of course the general public may well listen as much to business views as to politicians. Moreover, a weekend opinion poll for the Daily Mail for the first time showed a majority in favour of leaving the EU, although at present that appears an outlier. And the Conservative Party recently suffered defeats about the wording of the choice and the ability of government resources to be used to support the pro-EU case. That said, the experience from the Scottish Independence referendum and the general election is that markets don’t start pricing risks until relatively close to the event (and the impact tends to be more visible in volatility/risk reversals than in spot). Markets will also likely treat opinion polls with a healthy dose of scepticism after the general election experience.