Tomorrow’s Bank of England “super Thursday” combination of MPC vote, MPC minutes and Inflation Report (IR) seems biased to being a little more “super” than in August, although my base case is for MPC to continue treading cautiously. In particular:
• My modal case is for an unchanged 8-1 rate vote, but the risks are skewed towards Forbes and/or Weale joining McCafferty in voting for a rise, reflecting the likely bigger inflation overshoot and the passage of time (Forbes seems more likely, given her recent comments).
• A limited hawkish signal will likely be provided by the key 2-3 year inflation forecast moving further above target than in August (probably to around 2¼%) driven by the substantial fall in the market rate curve (up to 45bp lower, not pricing MPC rate hikes until 2017 Q2) and 1.7% £ERI depreciation since August, plus a potential narrowing of the UK output gap with the Blue Book GDP upward revisions. The slight weakening of UK data momentum (although still relatively strong) and the IR forecast catching up with China/EM concerns likely work in the opposite diection, although the offset seems likely to be partial. Markets shouldn’t get distracted by the likely weaker near term inflation forecast, driven by lower oil prices.
• The higher 2-3 year CPI forecast will likely be associated with Carney mildly pushing back on the dovish market rate profile, although the MPC minutes and press conference may well be a bit more dovish than the IR because UK rates have already repriced somewhat, and sterling has appreciated, after the after last week’s relative hawkish Fed message. Residual concerns about fuelling sterling strength also suggest that MPC won’t be overly aggressive.
• But MPC would likely still prefer mid-2016 rate hike to be priced rather than November 2016 currently fully priced (August around 80% priced). Moreover, some MPC members may not want to rule out February or May (journalist questions!).
• The dovish elements of the IR will likely include acknowledging slightly weaker UK data momentum (although remaining relatively strong), catching up with China/EM concerns, stressing that MPC wants to see higher unit labour cost growth to be consistent with inflation moving back to target (while acknowledging labour market tightness) and perhaps greater concern about weakening PNFC external financing (see charts below).
• On China/EM impacts I wouldn’t be surprised if the IR considered a wider range of cannels than the international trade impacts which have thus far underpinned MPC’s relatively relaxed attitude. I illustrate below that the UK banking sector has a substantial exposure to China (7% of UK GDP) and developing economies more generally (30% of UK GDP), although those are potential impacts should NPLs start rising.
• But the press conference will likely also feature comments on the need for UK households and business to start preparing for the possibility of higher Bank rates in 2016 (echoing Carney’s recent comments).
• Overall the risks seem skewed to the short end of the UK curve bear steepening and further near-term GBP upside. That said, near term this is less clear-cut than a few weeks ago when I started arguing that there was a mispricing. But my bias is for this dynamic to extend a little, with mild MPC encouragement and the market seeming more receptive to hawkish MPC hints after the Fed’s hawkish surprise. Such tendencies would be amplified by a higher inflation forecast (lower market profile plus narrower output gap) or further rate hike votes. But there’s also a risk of some GBP retracement should the MPC disappoint growing market expectations for MPC to somewhat mirror the Fed’s more hawkish stance.
• Beyond the near-term uncertainties further gradual GBP upside, especially against EUR, seems likely over the coming months as the policy divergence theme gathers momentum: rate differentials suggest that the mid-July EURGBP lows of just below 0.70 are not out of reach. Indeed, prospective ECB easing and a potential Fed December hike both raise the likelihood of MPC hawkishness, albeit for different reasons. Further GBP upside will, however, likely be contingent on the recent market risk appetite improvement persisting (Chinese data plus PBOC and ECB actions will be as important as what the Fed does) although it’s notable that GBP positioning is limited and neutral..
UK activity slowdown but underlying picture sound and output gap could have narrowed
Overall the UK activity seems to have slowed a little from the highs recorded a few months ago, even incorporating this week’s PMI bounces. MPC seem relatively relaxed about this slowdown, seeing it as a sign of strength not weakness, although it may nevertheless contribute to caution about pushing back too aggressively against dovish market rate pricing. But the big picture is that recent upside GDP revisions suggest that the UK output gap has narrowed.
The highest-profile recent UK data miss was the 0.5% Q3 GDP growth in the preliminary release – undershooting MPC expectation for 0.6% (eventually revised up to 0.7%). MPC will, however, likely take comfort from the undershoot reflecting weakness in the notoriously-volatile construction component (-0.14pp contribution to growth contrary to the strength of the construction PMI) with the services growth actually strengthening. While production output also rose, that reflected further strength in mining and quarrying (up 2.4% in Q3 after a 7.5% rise in Q2) which seems unlikely to be matched going forward, with manufacturing output continuing in the doldrums (down 0.3%). Indeed, GDP excluding oil and gas production, which is a measure of “core GDP”, grew by 0.5% in both Q2 and Q3, and provided an earlier sign of slightly cooler GDP momentum from the 2013/14 strength.
The MPC minutes were, however, quite pragmatic about the slowdown which was “consistent with the natural consequences of economy approaching a balance between its supply capacity and strengthening demand following UK recovery from financial crisis”. It’s a good news story not a bad news one, with many indicators remaining relatively buoyant. That pragmatism also reflected business surveys not falling off a cliff. So MPC will be reassured by this week’s bounce back in the manufacturing and services PMIs, which point 0.6% Q4 GDP growth. But those upticks, which have come after the forecast cut-off, seem likely to encourage only limited greater proactivity in pushing back against still-dovish market rate expectations because: (i) some of the PMI sub-components aren’t great e.g. services new business and expected activity remained low; (ii) MPC may regard the sharp manufacturing PMI bounce with some suspicion; (iii) the CBI and BCC surveys paint bleaker manufacturing pictures.
One further dovish concern at the margin is the weakening of external finance raised by PNFCs – and the potential downsides for business investment (wich was revised substantially down in the Blue Book). I’ve been worried about the weakness of lending flows to Euro Area PNFCs for a while (see here) but a little-appreciated fact is that the UK situation actually isn’t that different . M4 lending to UK PNFCs has remained moribund in comparison to the well-known strength of lending to UK households (which continues to outpace the EA equivalent, see Chart). The BoE’s latest Credit Conditions survey also suggests little prospective change in this situation, with both bank’s willingness to supply credit to PNFCs and PNFC’s demand for credit flatlining (although previous rises mean that this isn’t at too bad a level). But its also notable that the wider total external financing of PNFCs has fallen back from the H1 strength mentioned in the August IR as bond/equity issuance has failed to offset the weakness of borrowing from banks. MPC have, however, thus far been quite optimistic on PNFC investment prospects, given the strength of surveys of investment intentions. And the chart below illustrates that the investment intentions scores from the BoE Agents survey remain solid enough overall, suggesting that PNFCs are funding investment from retained earnings, although there’s a dip in the manufacturing sector and the (less timely) BCC survey is also less optimistic. So overall this probably represents something to keep an eye on rather than an immediate downside risk.
The October minutes were also sanguine because consumer confidence remained elevated. So the fallback in the latest GfK data, which MPC have attached considerable importance to, will likely disappoint them a little although the level remains relatively elavated. The fallback in the major purchases component was particularly sharp, although UK consumers remain considerably more confident than their EA peers. The MPC judgment that a modest housing market improvement is in train looks sound – supported by continued low mortgage rates and upside news to mortgage approvals/secured lending – and leading to an improvement in housing investment.
A potential bigger picture issue, however, is that the recent ONS Blue Book revised up the level of GDP by 0.7pp. Given that in August the MPC thought that the output gap was only 0.5% of GDP, on its own this implies that the UK output gap has closed or at least narrowed substantially. Of course, MPC could choose to commensurately raise potential output: they’ve previously motivated such a convenient fix by reasoning that inflation hasn’t been revised. The October minutes didn’t discuss the levels issue but noted that they’d need to look further into the changed composition of demand (stronger consumption, weaker investment and smaller current account deficit). But the minutes reiterated that unemployment was close to medium-term equilibrium rate and featured an extended discussion of the BoE Agents evidence of widespread skills shortages and firms reportedly planning pay increases to overcome this (I discussed this here).
But MPC were also clear that despite the apparently tightening labour market, subject to lower hours worked suggesting some extra margin of slack, higher pay growth needed to be set alongside signs of improved productivity. The bottom line, which will likely be repeated in the press conference, is that MPC need to see higher unit labour cost growth to support CPI returning to target. Indeed, the October MPC minutes also downplayed the apparent strength in the raw ULC data (arguing that underlying growth could actually be up to 1pp lower than the ONS’s raw 2.2% figure).
International situation less stressed recently – but IR to examine impacts more carefully?
MPC have thus far been relatively sanguine on the impact of the China/EM slowdown. Indeed surprisingly more sanguine than the ECB or the Fed (at least until they changed their mind last week, see here). Specifically, the October MPC minutes concluded that argued that there were “Few signs of a marked weakening in Chinese activity and so far few signs of a material effect on business and consumer confidence in advanced economies.” Moreover, Chinese data seem to have bottomed out (MPC, like the Fed, may feel more obliged to believe them than I do) and the PBOC have again come to the rescue (apparently signalling that they don’t really believe the data!). Draghi’s 22 October signal that the door to further ECB easing, including further deposit rate cuts, also supported market risk appetite and likely means stronger EA demand for UK exports whatever the ECB eventually decides: EA demand will be supported if the ECB acts aggressively in December (as I expect), but if he ECB ends up being aggressive that will likely be because EA demand is (organically) stronger. Heads UK exporters win, tails they don’t lose (and such demand effects tend to exceed the impacts of FX movements such as the likely further decline in EURGBP).
That said, the August IR predated the concerns about China/EM slowdownhat have occupied markets in recent months, so the forecast catching up with this levels impact could be another source of downside pressure. MPCs sanguine take on China/EM impacts on the UK thius far has been importantly motivated by the UK’s limited trade exposures to China/EMs. I noted such low exposures in August, while MPC member Forbes argued that the UK had the third-lowest trade exposure to EMs of the major advanced economies (see Chart). That said, trade flows only represent a small subset of the potential vectors of contagion from the China/EM slowdown: broader channels such as financial markets, capital flows, banking sector and confidence should be considered. And one hopes that the BoE’s economists have been busy examining such wider impacts – so I wouldn’t be surprised to see material on this in tomorrow’s Inflation Report.
But in the meantime the chart above illustrates that the UK seems relatively exposed via the large external claims of UK banks. The 7% of annual GDP in banking sector claims over China, up from 2% of GDP in 2010, and dwarfs German banks’ 1% of GDP exposure. Moreover, UK banks’ claims on developing countries as a whole amounts to a more significant 30% of UK GDP (versus 7% of German GDP for German banks). Of course, such numbers represent the potential impacts should NPLs on EM lending start accumulating. But they are neverthless somewhat sobering.
Inflation forecast likely further above target with lower market profile
The fall-back of headline inflation into negative territory (-0.1%y/y in September) was a risk noted in the August IR, although the staff had expected 0.1%. While that risk crystalizing is obviously a little more worrying that it not, MPC have been clear that they place little weight on such near-term inflation fluctuations especially given the impact of oil price moves, although core CPI inflation 1.0% is also disappointing.
The fall in oil prices (spot and futures) since the August IR means that the near-term CPI forecast is likely to be revised lower on Thursday from the relatively sharp rise anticipated in August (including base effects of previous oil prices dropping out of the calculation). But this shouldn’t surprise the market – they can obviously see oil prices and the October MPC minutes clearly signalled this likelihood (noting that CPI now appeared likely to remain below 1% until Spring 2016). That said, that market can be myopic at times – see here on the August IR reaction – so we can’t rule out some offset this time around even if markets now seem more attuned to hawkish MPC hints.
Rather the main news is likely to be the key 2-3 year inflation forecast moving further above target than in August. Overall it doesn’t seem implausible that the 2-3 year CPI forecast could lie around 2¼%, whereas it peaked at 2.14% in August and averaged 2.11% in year 3, and such an overshoot seems more likely to capture the market’s attention than in August (where they got myopically hung up on the lower near term forecast and the lack of further dissenting rate votes).
A higher 2-3 year CPI forecast can be motivated by the substantial fall in the market interest rate curve over the past three months – the 15-day averages feeding into the November forecasts are up to 45bp lower than their August equivalents – which will mechanically raise the medium-term inflation forecast. In essence there’s been a de facto monetary policy easing, which MPC didn’t want in August: the November market profile only prices in an MPC rate hike by Q2 2017, which seems overly dovish (as I’ve previously highlighted). The inflationary impacts of such lower rate expectations, plus a potentially narrower UK output gap, seem likely to outweigh the likely dinsinflationary impacts of weaker China/EM prospects (IR catching up).
Moreover, the 15-day sterling ERI average is 1.7% lower than assumed in August, again adding to inflationary pressures. Of course, the disinflationary impacts of the previous sterling appreciation also need to be considered. But the October MPC highlighted an active MPC debate on how previous GBP rises seemed to be having less than expected downward pressure on import prices (and hence CPI inflation), because of factors such as USD currency invoicing effects (see my discussion here) or because of the causes of GBP’s risen. The minutes concluded that “fairly rapid but incomplete” exchange rate pass-through was a reasonable start point, which would reduce the disinflationary impact of previous GBP strength (they also reduced their pass-through assumption in August IR, see here). But MPC also flagged that they would return to the issue in the November IR, increasing uncertainty about their forecasts.
A proceduural complication is that Fed’s relative hawkishness on 28 October (see here) has caused markets to start pricing somewhat earlier MPC rate increases – with a November 2016 rate hike now fully priced and an August 2016 rate hike around 80% priced in – together with a GBP bounceback (the 15 day £ERI average now lies only 1% below the August IR assumption). This suggests that the press conference comments will be more dovish that the IR forecasts: if they ran the forecasts today the 2-3 inflation forecast would be mechanically lower. But most of the MPC would likely still prefer mid-2016 rate hike to be priced in, which would still represent (in their minds) a more dovish move relative to their (Carney’s) previous stance of trying to encourage pricing of a Febrruary rate hike. Indeed, some MPC members may not want to rule out February or May (Carney’s response to any journalist questions on this will be interesting) although there may well also be residual concern about stoking further GBP strength by coming across too hawkish.
Modal case for another 8-1 vote but Forbes and/or Weale could surprise
Much of the disappointment around the August “super Thursday” was that the MPC vote was unchanged at 8-1. And my modal case is that this will again be the case tomorrow. But the risks seem skewed towards Forbes and/or Weale joining McCafferty in voting for a rise. While recent activity data don’t really support a decision change the likely inflation overshoot, apparent international stabilisation (and prospective ECB easing) plus the passage of time could potentially tip either over their thresholds.
Forbes seems most likely to vote for a rate hike, if only because she’s recently updated us on here views. Specifically, on 16 October she concluded that “The news on the international economy has not caused me to adjust my prior expectations that the next move in UK interest rates will be up and that it will occur sooner rather than later.” Martin Weale has, by contrast, kept his cards frustratingly close to his chest, so it’s hard to tell his direction of travel (if any) over his previous relatively-hawkish stance.
Some commentators have also Carney’s 25 October Mail on Sunday interview signalled him becoming less hawkish because he said described rate rises as a “possibility not a certainty“ and that if (undefined) “events mean that does not happen and rate rises are not appropriate, then we will do the right thing and we will not adjust rates”. To me it hard to draw strong inferences from such tautological comments although they could perhaps provide him with room to try and steer rate hike expectations to mid-2016 rather than Q1 (as he tried unsuccessfully to do in August). While Carney didn’t repeat his previous comment of the “process of raising interest rates will likely come into sharper relief around the turn of the year” he argued that “a lot of things are happening which are consistent with the idea of interest rates beginning to increase” and he semed focussed on preparing UK households and firms for rate rises, given high debt levels (he quoted 4% of all mortgagors likely struggling with repayments as rates rise) and “deciding the right time and place to do that” given that it “is far, far better to let the British people know so they can prepare“. MPC views such “real economy” communication as at least as important as its interactions with financial markets. So the line on houuseholds and firms preparing for rate rises seems likely to feature at the press conference.
Further limited rate repricing sterling strength likely, although less clear-cut than a few weeks ago
I’ve been highlighting for a few weeks that the market was being too dovish about the timing of UK rate hikes – arguing that May or August 2016 looked more plausible than the Q2 2017 that was being priced until the Fed’s hawkish turn last week – with commensurate potential for GBP upside given the close links with UK-foreign policy rate expectations. Indeed, I argued that he prompt for a repricing could be Fed hawkishness (given the UK’s “mini me” relationship with the US see here), as long as that didn’t undermine risk appetite (given that GBP remains a pro-risk currency). Given that scenario is pretty similar to what’s actually happened that leaves me in a difficult situation. Certainly the previous mis-pricing is now far less apparent, in light of the post-Fed shifts.
But overall, given the above, the risks seem skewed to the short end of the UK curve bear steepening a little further and limited further near-term GBP upside. The recent dynamic seems to have room to extend a little, with mild MPC encouragement and the market seeming more receptive to hawkish MPC hints after the Fed’s hawkish surprise. A 2-3 year inflation forecast more substantially above target (reflecting a potential double-whammy of lower market rates and narrower output gap) or a surprising 7-2 (or 6-3!) vote would magnify those effects. Conversely, should Carney disappoint growing market expectations of mirroring the Fed’s greater hawkishness (less likely but obviusly not impossible given the large opposing factor at play) then GBP could retrace a little near term.
But beyond such near-term uncertainties (which are obviously difficult to trade), further gradual GBP upside, especially against EUR, seems likely over the coming months as the policy divergence theme gathers momentum. Indeed, the prospective ECB easing (see here) and a potential December Fed rate hike (see here) both raise the likelihood of earlier BoE hikes: the former because it equates to stronger EA demand (for UK exports), the latter because it means that MPC won’t be breaking away from the dovish Central Bank peloton on their own.
Indeed, the recent outperformance of EURGBP relative to 2y swap differentials suggests room for further EURGBP downside as the FX market catches up: the mid-July lows of just below 0.70 seem likely to be re-tested on this metric over the coming months. But, as I’ve previously noted, further GBP upside will likely be contingent on the recent improvement n market risk appetite persisting, despite greater awareness of the potential for a December Fed rate hike (now priced as 50:50). Here the state of Chinese data plus perceptions of PBOC and ECB actions will be as important as what the Fed does. But it’s also notable that GBP positioning is fairly limited and neutral, suggesting the potential for GBP longs to be rebuilt. And the MPC’s apparent (provisional) more sanguine view on GBP strength reduces the likelihood of aggressive MPC jawboning (with gradual GBP rises).