The BoE was in distinctly dovish mode yesterday, despite inflation lying further above target at policy-relevant horizons. I’d characterise it as “pea souper Thursday”: the strong focus on EM weakness and more persistent disinflationary impacts from previous sterling strength echo recent foggy UK weather. The main lesson seems to be that MPC are keen to differentiate themselves from the Fed (which has recently backed off EM concerns) in an environment of increasing odds of a December Fed rate hike and December ECB easing with and sterling was showing signs of renewed strength. A bit of sterling and EM jawboning thus proved convenient, even if they generate questions (see below).
However EURGBP’s fall-back after today’s strong US payrolls (a December Fed hike is now 70% priced) suggests that MPC haven’t completely achieved their aim of banishing the Fed “mini me” comparisons. They also probably haven’t eliminated gradual EURGBP downside prospects over the coming months, although they have likely raised prospective GBPUSD volatility. And I’ve pushed back my expectation of MPC rate hikes a little to anticipate an August 2016 MPC rate hike (still ahead of market pricing given underlying domestic strength combined with some scepticism about MPC’s pass-through and EM judgements) rather than being evenly split between May and August.
Inflation Forecasts: weaker near term trumps further above-target at 2-3 years
As always, it’s important to remember that the Inflation forecasts should be viewed as much as communication devices as a pure forecasting exercise. They feature heavy doses of MPC judgement rather than being pure forecasting exercises (this contrasts with ECB forecasts being owned by the staff, although clearly judgement is also applied there) and so can be an effective mechanism for sending messages to the market.
And don’t completely lose sight of the fact that the inflation forecast was actually raised at the 2 and 3 year windows, peaking at 2.22% (not far from my call of 2¼) up from 2.14% as the lower market rate profile outweighed negative activity news (as I expected, with my prediction that they’d present further evidence on China impacts also prescient). Those are the horizons which should be driving policy, and Carney did mention that the projected overshoot at the three-year maturity was the largest since 2005, but markets’ myopic tendencies again showed through yesterday.
That was helped by Carney’s pushbacks against that the dovish market pricing being pretty weak/subtle, indeed he appeared a bit more forthright in August (when the market largely ignored him). In particular he noted that yesterday that “market yields would provide more than adequate support to domestic demand to bring inflation to target even in the face of global weakness” and “objective is to return inflation to target sustainably; that is, without overshooting the target once persistent disinflationary forces ultimately wane”. But both were probably a bit too long-winded for the market to pick up strongly on. And his subsequent more direct comment that it was “reasonably prudent to think BoE will raise rates in 2016” struggled against then-established dovish market dynamics.
Those nuanced comments were also drowned out by the more substantial downward revisions to shorter-term CPI forecasts and Carney’s comments about greater EM weakness and more persistent negative impacts of previous sterling strength. Indeed, the “ribbon” chart implies there’s at most a 56% probability of inflation being above target over the next three years, even with the substantially-lower market rate profile (although Carney again mentioned that this was the highest probability for a couple of years). And the “constant rate” CPI forecasts (i.e. roughly focussing just on the activity news) were actually revised down, by 20bp at the 3 year horizon, although they remain substantially above target (2.59% at 3 years).
Awkward catching up on EM stresses: banking sector worries?
The timing of the August and November IRs were awkward for capturing the impacts of the China/EM stresses. The August IR predated them while the time-consuming staff work for the November IR has apparently been finalised just as the market and indeed the Fed have become more relaxed about the situation (dropping the infamous international conditions sentence from the October statement) in light of apparently-stabilising Chinese data and PBOC easing.
The heighted EM focus is also puzzling given the previous MPC stance that the UK’s exposure is smaller than most other countries – Kirsten Forbes’ recent speech illustrates that UK exports to EMs are the third-lowest share of GDP of major economies (only 3% of UK exports g to China), although Carney has also previously made similar points. Of course, the effects are wider than direct trade flows (knock-on impacts on other countries, commodity and asset price falls, uncertainty & confidence hits). But other countries will also be affected by those broader channels. And the model simulations trying to capture such broader channels, included in the IR box (which my preview correctly anticipated), don’t exactly set the world on fire: a 3pp fall in Chinese GDP only reduces UK GDP by 0.3pp.
The IR is upfront about that EMs’ small share of UK exports, but argues that the growth downgrades are sufficient to lower UK-weighted world GDP growth, although the tables show that this is only by ½pp in 2016 (to 2¼) and ¼pp in 2017 (to 2½%) as Chinese growth slows to around 6% (with downside risks during the rebalancing period) and other EMs growth by less than 3% (i.e. nothing really dramatic). While Brazil and Russia are identified as facing domestic challenges, there’s not actually that much material in the IR justifying the MPC’s decision to downgrade its assessment of EMs medium-term growth prospects. I don’t really disagree with the direction of travel but the timing looks potentially awkward and it would be nice to see more meat (precise figures!) underpinning this important decision. Without that it again risks looking like a convenient way to keep inflation not too far above target (given underlying domestic strength) and hence constrain nascent sterling strength.
One aspect which the IR doesn’t really get into is the UK’s exposure to EMs via the large UK banking sector. The IR box alludes to this in theory (and potential knock on impacts on lending to the UK economy) but doesn’t include and data the model simulations (with apparently relatively small impacts) don’t sound like they include banking sector exposures. Carney did, however, express concerns about potential increases in non-performing loans in China/non-Japan Asia, in the wake of substantial rise in borrowing, in his Bloomberg TV interview. So this could be a way of justifying the elevated focus on EMs in the press conference.
Luckily, I’ve been putting together data on such exposures anticipating that the issue rising up the agenda. Below I repeat the chart I included in my MPC preview which illustrates that the UK’s substantial banking sector exposure to both China (7% of annual UK GDP) and developing countries more broadly (30% of UK GDP). Keep an eye out for the more detailed piece on such exposures, considering a wider range of countries, that I’m aiming to send out in the next few days.
Increased persistence of exchange rate impacts: judgement v recent evidence
The other major surprise yesterday was that MPC “refined” their estimates of exchange rate pass-through to CPI inflation: “the drag from import prices on CPI inflation will be protracted and diminish only gradually over the forecast period, such that the drag from past falls in import prices is likely still to be affecting inflation in two years’ time”. But this updated judgement runs counter to MPC recently puzzling over lower than expected pass-through to import prices and doesn’t seem supported by any updated modelling:
• On the first “leg” of pass-through the October minutes noted that “Over the past year, the decline in the prices of UK imports excluding fuels had been somewhat less marked than might have been expected given the change in world export prices and movements in the sterling exchange rate”. And that “An assumption of fairly rapid but incomplete pass-through to import prices, based on the average of past experience, was probably a reasonable starting point”. So no real reason to change the usual judgement (the Inflation Report box repeated this, as well as the reasons why such pass-through can vary over time).
• On the second “leg” of pass-through the Inflation Report box (page 28-29) show COMPASS model simulations that import prices’ impact on CPI inflation does indeed last a couple of years, although the peak impact is after a year. But the key thing is that there is also nothing new here – the COMPASS model properties have not been changed. So again no substantial reason to change the judgement.
So this looks like this is a pure judgement call from the MPC, which puzzlingly seems to run counter to the recent evidence of weaker impacts on import prices (the IR acknowledges the considerable uncertainties, which are familiar from when I used to look at this kind of thing at the BoE). Of course, this lowers the inflation forecast (keeping it handily below rates closer to 2½% at 2-3 years which would cause the market to take notice) thereby forestalling BOE rate hike expectations being brought forward and curtailing nascent GBP strength. In an environment of growing talk of currency wars, and with the door very much open to further ECB easing in December, a cynical commentator could draw inconvenient conclusions.
EURGBP reaction to strong payrolls questions whether MPC has achieved its aim
Of course, investors need to take account of the apparent switch in MPC thinking, even if it’s underpinning look puzzling. It probably implies that the recent relatively low GBPUSD volatility (recently been around 30% lower than the G10-USD average), based upon market’s viewing MPC as the Fed’s “mini me” (being the only two Central Banks at all likely to exit the dovish peloton) will be less apparent. MPC’s aim, after all, seems to have been to differentiate themselves from a Fed looking increasingly likely to follow through on their long-held plan to start hiking (slowly!) in December. But the jury is definitely still out.
Today’s very strong US payrolls data – with earnings growth rising to 2.5% (still below the UK equivalent!) employment up 271k and unemployment down to 5.0% – raised the market-implied odds of a December hike to 70% (double its probability only a couple of weeks ago). Unsurprisingly, this produced general USD strength, with DXY breaking out of its recent range to close above 99 for the first time since April. And GBPUSD also unsurprisingly fell. But it was interesting that EURGBP actually fell back relatively sharply from the yesterday’s MPC-inspired rise. Moreover, yesterday’s fall in UK OIS rate also partly unwound: positive US data do seem to have again been extrapolated to the UK/MPC situation.
While it’s clearly hazardous to draw strong conclusions from such small samples, this suggests that the MPC haven’t yet achieved their aim as stopping the market viewing MPC as the Fed’s “Mini Me”. The market seems to have concluded that if the Fed moves hikes in December then maybe MPC could hike next summer/Autumn after all. As such, further strong UK (or US) data could well see GBP re-strengthening on the nascent policy divergence trade.
So I continue to think that gradual EURGBP declines are likely over the next few months, albeit more slowly than prior to the MPC’s dovishness (0.70 could be an end-year phenomena) and as I’ve previously said subject to market risk appetite remaining supported (an actual Fed liftoff could damage it but ECB and PBOC dovishness will be supportive). After all, Draghi has a record of over-delivering when the chips are down (albeit with the caveat that the EURUSD decline below 1.075 reduces the pressure). Certainly, MPC seems to be in a different position to EA satellites like the Riksbank (see here) and SNB who will likely be forced followers to ECB dovishness (subject to bond market constraints). Any escalation of BREXIT risks is certainly a latent negative for GBP but it may welll lie dormant over the next few months.