Caution in Threadneedle Street: weak pay growth supportive near-term but watching the Fed carefully

This morning’s surprisingly-weak UK pay data provide further ammunition to the dovish MPC members and the growing sense that the Committee really is in no rush to start raising interest rates and want to try and differentiate themselves from the Fed. That said, the recent UK pay growth slowdown has limited implications for inflation under two of the MPC’s explanations and UK pay growth looks similar to US pay growth on a like-for-like basis (as does low unemployment). But given the current UK data dynamics I’m not expecting any great spillovers from a (dovish) Fed hike tonight to MPC rate hike expectations.

MPC will nevertheless likely be watching carefully whether Yellen manages to achieve the aimed-for “dovish hike” tonight and over the coming weeks, which would give MPC more confidence to follow suit in 2016. Indeed, MPC continue to emphasise that they want to “return inflation to target sustainably…without an overshoot“, which isn’t the case were Bank Rate to follow the dovish market path (see November Inflation Report and here). And MPC will be likely reassured by recent evidence that UK households have become better able to absorb a rate rise.

But for now they’re also stressing how headline inflation seems likely to remain below 1% until H2 2016, that renewed oil price falls (Brent below $38 today) increase “the likelihood that headline inflation rates would remain subdued” and the persistent negative impacts on inflation of previous sterling rises. So they’ll likely take comfort in sterling’s recent ECB-driven fallback. But current very dovish market pricing of MPC action (February 2017 hike) mean that the risks seem skewed to an eventual re-pricing forwards and GBP support in the coming months. The other corollary is that near-term GBP movements may well also be driven mainly by foreign developments.

Pay growth weakening despite falling unemployment and high vacancies

The sharp fall-back in regular pay growth to its slowest pace since February 2014 – to 2.0% on a whole-economy basis and 2.4% in the private sector – despite ILO unemployment falling to its lowest since May 2008 (5.2%) certainly asks important questions about whether pay growth has stalled. The surprise is amplified given that job vacancies have risen to a record (post-2001) high, although the vacancy/unemployment remains slightly below its 2004/5 peak, with the BoE agents previously reporting that this was provoking pay rises. Moreover, the single-month earnings growth rates are even lower: 1.7% (2.3%) for whole economy (private sector) regular pay growth.

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So the concerns about pay growth plateauing expressed in last week’s MPC minutes seem prescient. But today’s further slowdown doesn’t seem driven by the “batting average” effects discussed in the minutes: while average hours worked has fallen in recent months (especially in full time jobs), average weekly hours actually rose marginally on the months and were the same as three months ago. There’s also no new evidence on the compositional shifts that MPC think could also be contributing to the weak pay growth. Importantly, it’s not clear that the market has registered that MPC think that an earnings slowdown won’t pull down inflation if it’s driven by either of these factors (as they’d also reduce productivity and hence leave unit labour cost growth unaffected).

MPC Concerns about lowflation affecting pay bargaining but inflation expectations steady

The MPC’s most worrying potential explanation for the AWE growth slowdown is that low CPI inflation outturns have started feeding back onto pay claims, according to BoE Agents’ contacts. But MPC also think that this potential effect will lessen as inflation picks back up – they will be hoping that this happens in time for the Spring wage negotiations. But a further reason to be sanguine is that survey-based inflation expectations have remained steady despite headline CPI inflation dipping below zero a couple of times: if UK households continue to expect inflation to bounce back it’s not clear why they’ll start cutting their pay claims. It’s also interesting that UK breakeven inflation rates have been much more stable than those of the Eurozone or the US – and indeed far less correlated with oil price movements. Nevertheless this is something to watch very carefully, given that the scenario would be worrying.

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UK and US pay growth aren’t that different when compared on like-for-like basis

The fallback also means that UK AWE growth has dipped below US average hourly earnings growth (2.3% y/y in November, down from 2.5% in October). But, in the spirit of comparing like with like, UK AWE growth actually slightly exceeds the growth of US average weekly earnings (2.0% y/y in November). The Fed is apparently betting that the US Phillips curve will kick in over coming months with the U3 unemployment rate of 5.0% approaching the NAIRU. Today’s fall in UK unemployment to 5.2% mean that the MPC may well reach a similar conclusion before the February 2017 liftoff currently anticipated by markets.

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MPC Not Unhappy to have seen Sterling fall back

Another of the MPC’s current bug-bears is the persistent impact of (previous) sterling strength on inflation (although they’ve vacillated a bit in recent months, see here). So the GBP fall-back, with the TWI down 2.7% since early August, driven by EURGBP’s rise after the ECB’s surprising hawkish ease on 3 December (see here), will have provided some relief to them. That said, the TWI is still up more that 5% since stert-2015, largely reflecting a fall in EURGBP after previous ECB dovishness.  Interestingly, this morning’s weak pay data had a (surprisingly) muted impact on sterling (down just under 0.2% against both the EUR and USD), with the market likely more focussed on the impending Fed decision.

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With the MPC’s dovish stance currently backed by the weaker pay trends, low inflation and oil price weakness, there seems little immediate prospect of expectations of early policy tightening supporting sterling. That said, current market pricing of the first MPC rate hike in February 2017 looks excessively dovish (even if both Broadbent and Shafik have reminded us that market prices are mean not modal expectations). I continue to think that August 2016 looks more likely, although today’s weak pay data mean that the risks are now skewed to a little later. But given the extent of dovishness priced in, MPC rate hike expectations may well be brought forward in the early months of 2016 if the economy continues to progress satisfactorily (as I expect). Clearly, pay dynamics will be important as emphasised by MPC and discussed above.

But there may also be flow-based support for sterling: the ECB’s deposit rate cut further into negative territory will make UK assets more attractive. And it’s notable that foreign purchases of UK government debt have been fairly strong in recent months (including a record-large inflow into gilts in October). So I’m not convinced that the UK’s large current account deficit will drive GBP substantial weakness, at least in the next couple of months.

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Of course, current account deficits are one of those “not a problem until it’s a problem” issues. And it could interact with growing BREXIT risks, given the apparent closeness of opinion polls (as if we believe them) and uncertainty about what the Government can achieve in its negotiations: foreign investors may demand a higher risk premium on UK assets if they start thinking that BREXIT is a live possibility. And BREXIT uncertainties could potentially slow the economy via weaker investment and consumption (precautionary savings).

Tomorrow’s EC meeting will provide greater clarity on the extent to which PM Cameron’s demands are likely to be runners (with restrictions on migrant benefits obviously the most contentious and the omens don’t look good). Past experience suggests, however, that such risks do not tend to get priced into FX until a few months before the event (we don’t yet know the date of the In/Out Referendum, but it seems to have slipped later in recent weeks). That said, with the Fed uncertainty (hopefully) out of the way, investors may be looking for another theme to trade on.

Watching closely whether Fed can pull off a dovish hike

The MPC’s communication strategy has many similarities with that of the Fed: both stressing data dependency, gradual rate rises after liftoff (forward guidance) and that (representing a lessening of the degree of accommodation rather than a tightening). Indeed, the BoE is the only other major central bank apart from the Fed that’s anywhere near to raising rates, given some reasonably-strong big-picture similarities in their data (see above on labour markets, plus the manufacturing sectors in both countries are suffering). Despite that, not expecting any great immediate spillovers from a (dovish) Fed hike tonight to MPC rate hike expectations. MPC have got their message across clearly and it seems likely to stick in the near term (but be potentially more challenged in 2016).

But MPC will be watching very carefully whether (and how!) the Fed manages to pull off the “dovish hike” that it seems to be aspiring to, aiming to avoid a US Treasury sell-off have or a renewed bout of USD strength (given concerns about exports and manufacturing). If Yellen is successful in the days/weeks ahead that will likely make MPC more relaxed about entertaining a rate hike in 2016.

While 2 UST yields have risen fairly sharply this week (up from 0.875 on Friday to tantalisingly close to having a 1-handle today), my views last week that EURUSD would be range-bound while there was room for further USDCAD upside on further oil price weakness (see here) have proved pretty accurate. ERUSD has not strayed too far from 1.09 whereas USDCAD has broken through 1.38 today, from around 1.36 when I wrote last week.

As I discussed last week I expect Yellen to achieve a dovish hike by a combination of careful drafting of the policy statement, potential falls in the “dot plots” and downward revisions to the inflation forecasts plus a dovish press conference. Indeed, given that the actual rate hike is now largely priced these dovish elements may well lead to some limited USD retracement after the announcement (on profit taking), although this is clearly a close call and will be very dependent on what Yellen says which only she knows. And near term oil price weakness seems likely to be at least as strong a theme in global markets as Fed actually imlementing the much-flagged hike, supporting USD against oil producers like CAD.

But the Fed-ECB policy divergence theme may well gather further momentum in 2016 as the US economy comtinues to perform well (with inflation ) and the ECB potentially coming back reluctantly with further easing.  And the ECB’s move further into negative rates may well accelerate portfolio outflows from the euro are into the US and the UK.

UK Households seem better positioned to absorb interest rate rises

One factor that’s been worrying BoE about raising rates has been the potential adverse impact on indebted households, and the consequent hit to consumption potentially stalling the recovery (where consumption has been an important driver, although Capex has also been contributing and the erratic net export contribution may eventually be revised to something smoother). But the latest BoE/NMG household survey provides ground for cautious optimism. Specifically, it indicates that 31% of mortgagors would need to take actions such as cutting spending, working longer or changing their mortgage in response to a 2% interest rate rise (magenta line in Chart). But, importantly, that’s down from 37% in 2014 and 44% in 2013. And obviously a 2% rate rise is some way off, allowing incomes to rise in the interim. Indeed, only 2% of mortgagors reported need to take actions in response to a 2% rise in mortgage rates if their incomes are assumed to rise by 10% (blue lines in Chart).

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