BoE: Scary Monsters (and elephants in the room)

This note details my expectations for the latest Bank of England “super Thursday” as well as the (related) implications of Brexit uncertainties (“scary monsters”). The latter have thus far been an elephant in the room in MPC discussions, notwithstanding Carney’s recent comment about funding the UK large current account in Febrile market conditions. The main points are:
• On top of international uncertainties MPC faces challenges over surprisingly-weak wage growth, potential Brexit uncertainty effects and a high banking sector EME exposure (see here).
• While the Inflation Report and minutes are likely to be dovish, reinforcing the message about MPC being in no hurry to raise rates, market pricing is already exceptionally dovish (2016 rate cuts partially priced, first MPC rate hike not until Q1 2018).
• So the immediate market impact of the IR/minutes will likely be limited unless McCafferty does a U-turn or markets are again myopic (focussing on the impact of the oil price collapse on near-term inflation forecasts). My small skew is towards a further limited knee-jerk GBP fall driven by such a dovish interpretation.
• MPC worries about low inflation feeding back onto wages, supported by simple econometric evidence, can rationalise market myopia.
• MPC may also start getting concerned about low household inflation expectations and the 25bp fall in 5y5y breakevens since November (not dissimilar to the EA fall which helped motivate fresh ECB dovishness, see here).
• While the 3-year inflation forecast is again likely to be (marginally) above target, supported by the lower market rate profile and GBP’s 6.5% fall offsetting the oil price fall, that more hawkish message may well again get lost in translation.
UK activity prospects continue to look solid, if lower than in 2014, but risk being hit by Brexit-related uncertainty impacts (e.g. on thus-far solid capex or by denting high consumer confidence) as well as the fiscal consolidation. That, plus net exports and manufacturing being suppprted by GBP’s recent falls means that we’re likely to see a further growth slowdown before a H2 pickup (if “remain” wins the referendum).
• Sterling’s 6% fall in the recent risk-off environment reflects GBPs’ general pro-risk characteristic likely being amplified by growing Brexit concerns.
• On Brexit scenarios FX traders face the difficult task of trying to price an event with considerable uncertainties about both its likelihood and impact. Higher risk GBP risk premia is the likely result, making it difficult for GBP to rally substantially on positive UK data.
Risk reversals indicate growing GBP downside risks, although they seem likely to rise further given that they are less than around the Scottish referendum and generally tend to rise in the couple of months before the risk event.
• Based upon a 50/50 chance of Brexit and past impacts of crisis situations GBP could fall a further 3-6% in the run up to the likely June EU referendum (before rebounding sharply on a “remain” vote of potentially collapsing on a “leave” vote).
• By contrast gilts thus far do not seem to have been affected by Brexit uncertainties. But the risks seem skewed to gilt term premia rising: UK 2s10s seem likely to steepen.

Super Thursday sees MPC faced with a challenging environment, with UK specific uncertainties

This weeks’ Bank of England “super Thursday” jamboree sees the MPC facing a number of important challenges and uncertainties. The global factors or sharp oil price and equity falls on China/EM concerns (amplified by recent poor G10 data, but with some recent stabilisation) and lower government bond yields are a handful to begin with.  They’ve already driven Draghi strongly hint at further ECB action (see my explanation why here) and the Bank of Japan join the negative interest rate club (albeit for a subset of banks’ deposits and more driven by stemming Yen strength). But MPC also have to deal with UK-specific uncertainties such as whether the recent pay growth slowdown is a temporary lull of portends to something more ominous, whether the UK recovery could be derailed by EU referendum uncertainties (the elephant in the room and the disproportionate impact of an Asian slowdown on UK banks (see here).


But market already pricing very dovish MPC: more difficult to get fresh dovish push

So there are strong reasons for the Inflation Report and MPC minutes to be decidedly dovish. Certainly the January MPC minutes’ conclusion that “In broad terms, the outlook was similar to how it had appeared at the time of the Committee’s November Inflation Report.” looks outdated.  The overarching message seems likely to again be that MPC are in no hurry to start raising rates, with the extra leg of them analysing the evolving situation carefuly.

That said, Governor Carney’s “Turn of the year” speech (with his three necessary conditions for gradual rate rises seeming some way off, even if core inflation surprisingly rose to 1.4%) has likely stolen most of Super Thursday’s thunder.  Following that and the ECB/BoJ moves, markets are now not anticipating the first MPC rate hike until Q1 2018, with a significant chance of a 2016 rate cut priced.  But the dovish market pricing means that the odds seem stacked against major extra dovish news on Thursday.  The main candidates here seem to be: (i) McCafferty doing a U-turn and votes for unchanged rates – a 9-0 vote seems completely possible (McCafferty did a u-turn in January 2015 in not dissimilar circumstances); and/or (ii) markets again focussing mypopically on the likely sharp downward revision to the near-term inflation forecast driven by the oil prices’ plunge (such mypoia was evident in November and is now more defensible with MPC concerned about low inflation feeding back onto wages, see below).

3 year inflation forecast may again be above target, but could get lost in trsnalation

Conversely, there’s a good chance that the more policy-relevant 2-3 year inflation forecasts will again be above target. And that would be MPC’s way of signalling that it’s not rubber-stamping very dovish market expectations. While the oil price plunge drives the near-term inflation forecast lower, further out the impact of the substantially-lower market rate profile and the 6.5% sterling TWI depreciation since November (5% using 15-day averages) will both mechanically support inflation (although the partial pricing of 2016 MPC rate cut post-dates the IR data cutoff).


But there’s plenty of room for this less-dovish MPC signal to get lost in translation. First, the forecast inflation overshoot three years out may well be smaller than the 22bp in November, which the market didn’t pay that much attention to, depending on MPC judgements. Second, the “ribbon” chart (probabilities of inflation being above target at different maturities) and constant interest rate inflation forecasts could well add weight to dovish interpretations as they did in November. Third, current febrile conditions could lead Carney to spend (even) less time than he did in November stressing that inflation needs to return to target “sustainably” (not overshoooting sigificantly).  Fourth, markets may pay even less attention than normal to the three-year inflation forecasts in the current highly-uncertain environment.

Slide3 Slide4

So while current market pricing seems too dovish – November 2016 or February 2017 seem more likely MPC liftoff dates to me (once Brexit uncertainties hopefully fade) and a rate cut seems unlikely (but not impossible, see below) – this week is probably not the best time to be trading that view and/or hoping for a GBP bounce unless market risk appetite recovers.  Indeed, GBP seems likely to continue to be hamstrung by its’ pro-risk characteristic while markets remain febrile and EU membership uncertainties persist.  The Chart below illustrates that the up to 7% GBP TWI fall since November has considerably exceeded the fall implied by short rate differentials, contrary to the usual relatively close link, consistent with Brexit concerns impacts. As discussed further below, GBP would likely suffer further should Brexit concerns rise in advance of the likely 23 June EU referendum. And gilt term premia would likely rise, even though they’ve been surprisingly-dormant recently (UK 10-year yields have fallen the most in the G10 since November). 


Puzzling weakness of wages: MPC getting concerned about second round effects

As mentioned above, focussing more on the near-term inflation forecasts may be more rational with MPC more concerned about low inflation feeding into wage-setting.  Indeed, the surprising weakness of pay growth is the most significant domestic macro development since the November IR. Headline AWE growth has fallen to 2.0% versus 3.3% six months ago (regular pay growth down to 1.9% from 2.8%) despite the unemployment rate falling to 5.1%, the lowest since October 2005. And the previous tight link between wage growth and the vacancy/unemployment ratio, whose extremely elevated level suggests that wages should be rising sharply rather than turning down, has apparently broken down.


Even Martin Weale has acknowledged that the puzzle means that wage growth isn’t yet consistent with inflation being at target. And Kristin Forbes summarised it as “Although economic models and theory suggest an important link from unemployment to wage growth, [and then] to inflation, the links in this chain have grown weaker recently”. So she wishes to see more evidence to “build confidence that the normal chain of tight labour markets feeding through into higher wages is still intact“. In other words, MPC need to determine whether it’s a temporary lull in wage growth, with high vacancies eventually pulling up wage growth as the Phillips Curve reasserts itself, or whether something more fundamental’s going on.

And the most worrying potential explanation is that recent low (headline) inflation is feeding through into lower wage bargaining.  That’s especially concerning as we’re about to enter the key spring wage negotiation period.  Such second round effects are anathema to Central Bankers and cause them to stop “looking through” temporarily-low inflation. And Carney’s speech featured some simple econometric evidence indicating such impacts on wage growth from lower inflation: the green bars in the chart below show the estimated impact of inflation of wages, and they disappear in the last few months. Conversely, wage growth is estimatd to be supported by low unemployment and recruitment difficulties (red and purple bars). That said, such simple OLS evidence is far from the end of the matter – it’s pretty mechanical and won’t really pick up any change in behaviour, plus it leaves a fair bit of the recent AWE weakness unexplained.


So the IR/Minutes could well see MPC exploring the full range of explanations for weak wages before concluding that all hell is about to break loose (and they need to be extra dovish to counteract it).  The other explanations for the AWE slowdown include: (i) lower average hours per week – although their recent bounceback undermines this candidate , see above; (ii) compositional effects like younger workers taking on the new jobs; and (iii) the equilibrium unemployment rate being lower than previously thought.  But it’s always nigh-on impossible to decisively distinguish between the different explanations in real time.  So, given current febrile condisions MPC may well end up resuscitating the cautious risk-management approach that seemed to be going out of favour last summer (see here), as well as waiting for further data.

Low households inflation expectations & falling inflation breakevens

But MPC concerns about second round effects will also likely be bolstered by households’ near-term inflation expectations edging down in recent months (see chart) – as it makes them more willing to accept low pay rises – albeit only to levels seen in early 2015.  Households’ medium-term inflation expectations are also lower than a year ago, albeit with a small bounce in the latest data.

Slide14 Slide13

But MPC will also likely be concerned by the 25bp decline in UK 5y5y inflation breakevens since November alongside the oil price collapse.  Over the past nine months I’ve banged on about the fragility of EA inflation breakevens and the consequent need for the ECB to act (see here for my latest) but during most of that time UK breakevens have been resassuringly-stable (see e.g. here). But that hasn’t been true since November.  And that should worry MPC (subject to the usual caveats about breakevens including risk and liquidity premia as well as underlying inflation expectations).

Activity indicators doing OK: but potentially vulnerable to Brexit uncertainties

The broad picture from UK activity indicators in one of steady growth, albeit weaker than in 2014.  But growth could well slow further in the near-term before again picking up in H2.  Q4 GDP suprised margially on the upside with 0.5% q/q, as services activity more than accounted for the growth, while production (manufacturing) has been suffering from the global slowdown and the earlier GBP appreciation.  Construction has also been in the doldrums. Growth neverthless slowed to 1.9% y/y, down from 3.0% in mid-2014.  The expenditure components (only available to Q3) indicate that consumption growth has remained strong and the main growth driver. But both capex and, perhaps surprisingly, government consumption made continued positive growth contributions.  But net exports have detracted from growth (that previous GBP appreciation again) as did de-stocking.


Looking forward, consumption seems likely to continue suppporting growth – low unemployment and strong employment growth are supporting labour income growth, even if earnings growth has slowed (see above).  And consumer confidence has bounced back from its recent dip, with continued strong appetite to make major purchases. Such high confidence could, however, be dented by the uncertainties related to Brexit (precautionary saving effects).  Similarly, UK capex plans could also be hit by such  uncertainty effects (the “option value of waiting” to undertake inestment will rise).  So we could well see a further growth slowdown into mid-year and the EU referendum.  But such a hits should be temporary (it’s a timing thing) if “remain” wins the day (and all hell could break loose if “leave” win) consistent with a H2 bounceback.  Such a rebound will likely also be supported by GBP’s recent depreciation supporting net exports and manufacturing (or at least curtailing their recent falls). But the UK’s prospective large fiscal consolidation (the largest in the OECD) means that the growth support from government consumption is likely to disapper.


I’m intending on having a deeper look at the evidence of Brexit uncertainty effects in

GBP: risk appetite to dominate near-term, Brexit concerns could grow

As disusssed above, “Super Thursday” is unlikely to be associated with major monetary policy fireworks.  But the risks seem slightly skewed to further near-term GBP weakness should markets again myopically focus on the downward revision to the near-term inflation forecast, rather than listening to likely weak MPC pushback against very dovish market expectations, and if McCafferty does a U-turn. But the GBP reaction to the IR seems likely to be contained in either direction.

As mentioned above, current market pricing of potential 2016 MPC rate cuts and the first rate hike in Q1 2018 look too dovish.  So eventually they seem likely to be re-priced, supporting GBP.  But given Brexit uncertainties and febrile market conditions that seems more likely to be a H2 2016 development (if the referendum votes to stay in the EU) rather than a near-term one.  Obviously positive UK data outturns, such as last week’s better than expected GDP data and Monday’s better than expected manufacturing PMI, will support GBP. But while the risk premia on UK assets remain elevated it will be difficult for GBP to progress (except against other risky currencies like NOK and CAD as well as fragile EM currencies).

Indeed, the evolution of market risk appetite and Brexit concerns seem likely to be important drivers of GBP prospects over the next few months. And the significant challenges facing the global economy suggest that risk appetite is unlikely to improve significantly over the next few months. So GBP seems unlikely to be substantially-supported by retracement of a GBP risk premia in the next few months, especially given that Brexit concersns will in any case likely rising.
• ECB and BoJ action plus reports of a prospective OPEC-Russia oil supply cut deal have calmed markets near-term (see Chart below) – Monday’s continued weak of China PMIs caused signifucantly less ripples than the January releases – and GBP has consequently recovered a little (also helped by the better UK data).
• But the global situation remains fragile and could easily be reversed if the oil rumours prove unfounded, poor data/corporate earnings eventuate or indeed markets starting doubting the efficacy of Central Bank firepower (it’s notable that US 5y5y inflation breakeven have also fallen sharply in 2016).
• A substantial improvement in risk appetite would require China/EM worries to dissipate, the ECB to ease further, and the US economy to steam ahead (or a the FOMC to validate very dovish pricing if it doesn’t).
• Friday’s US payrolls numbers and Yellen’s testimony next week will likely be important near-term market, in the wake of the less dovish than hoped for January FOMC statement.


The impact of GBP’s amplified pro-risk nature in the  recent 2016’s risk-off market environment is captured in several different metrics: (i) GBP has been notably weaker than implied by its’ usual driver of relative short rates (policy expectations) – a chart above illustrated for the TWI while the chart below demonstrates that it’s the case even for EURGBP and despite Draghi’s fresh bout of dovisness; (ii) GBP’s fall has been sharpest against safe haven currencies like JPY, but smaller versus oil FX and other riskly currencies; (iii) GBP’s weakness has been unusually-highly correlated with equity prices (see chart below); (iv) GBP has moved in line with reltive policy rate expectations against other pro-risk currencies like NOK, CAD and AUD (see chart below).



Alongside this, risk reversals have moved to price in greater further GBP over the coming months (high demand for GBP puts), particularly over the maturities encompassing the likely June EU referendum (see Chart above).  Indeed, EURGBP 6m risk reversals are already more stretched than around the May 2015 UK General Election (although GBPUSD risk reversals aren’t).  But risk reversals currently price less downside GBP risk against both EUR and USD than before the September 2014 Scottish Referendum.  And as such there’s ample room for them to rise further in the run-up to the likely June referendum: the experience around previous UK risk events is that markets tend to get most nervous a month or two before the event.

The earlier focus on Brexit reflects the stressed market conditions and the apparently finely-balanced decision really being a once in a generation event with likely major implications.  GBP traders face the very tricky task of trying to price the weighted average of two outcomes (“stay” versus “leave”) with likely very different implications.  But theres considerable uncertainty about both the appropriate weights to use (chances of “stay” versus “leave” winning, with likely sustantial scepticsm about opinion polls after the General election disaster) and the implications of the different outcomes.  Much of the initial reaction to today’s Draft EU deal has been “is that all?” (even if it’s probably as good as Cameron could have obtained in the circumstances). So the “stay” camp have got their work cut out, espeially as the probable June poll likely coinciding will a renewed surge in refugee numbers. That said, the “leave” camp isn’t currently the most organised, preferring in-fighting over accreditation/funding.

But where, in ballpark terms, could GBP head in the eventual “remain” and “leave” scenarios? An eventual “remain” vote would likely see the GBP appreciate as the risk premium on UK assets unwinds and the underlying positives on the UK economy shining through (assuming the golden goose hasn’t been killed in the interim by the uncertainty effects of Brexit uncertainties).  EURGBP back around 0.70 would be achievable, potentially lower if the ECB extended QE as well as cutting rates in March, while GBPUSD would likely again trade around 1.50 (assuming EURUSD at 1.05).  A “leave” vote could well see capital flight (the UK’s large current account deficit coming to the fore) and resultant sharp GBP depreciation.  GBP’s sharp fall in the 2008 finacial crisis (which I discuss in my Bank of England Quarterly bulleting article here) could provide a template.  Specifically, EURGBP then rose to an average of 0.90 in Q1 2009 (or GBPEUR of 1.10), which would imply GBPUSD at 1.17.  That could be overstating the falls (although this decidedly a known unknown).  But even the the 2009-14 average for EURGBP is 0.85, imply GBPUSD around 1.24.

The probabilities of the different scenarios are also extremely difficult to determine.  Opini0n polls currently seem to give “remain” a small lead over “leave”, although three recent polls also put “leave” marginally ahead.  Of course those opinions can change in light of today’s draft deal (and considerable press criticism).  Plus its hard to trust opinion polls after the General Election debacle.  So a simple coin-toss 50/50 probability is unfortunately likely the neutral assumption.  Based upon the above spot rate scenarios that implies EURGBP around 0.78-0.80 (GBPUSD around 1.31-1.35) on the eve of the poll i.e. up to a further 6% GBP depreciation over the next few months.  My personal probabilities, would however be more like 70:30 in favour of “remain” – and that would imply only a 1% further GBP fall (EURGBP rising to 0.76 again).

Gilts: surprisingly little impact thus far, but that seems likely to change in the coming months (2s10s to steepen)





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