The following previews Thursday’s BoE May Inflation Report (IR) and MPC minutes. Overall MPC seems unlikely to give a strong policy steer, given the proximity of the EU referendum vote. So rate and FX market impacts are likely to be limited – although probably dovish at the margin (and perhaps a bigger FX impact) despite the likely upward revision to the MPC’s inflation projections, much like in February. The main points are:
• The IR’s detailing of the adverse near-term real-side impacts of Brexit uncertainties will probably be interpreted dovishly by the market. That said, MPC probably won’t want to get bogged down in politics e.g. by explicitly spelling out separate ‘remain’ and ‘leave’ inflation projections, not least given the considerable uncertainties.
• There’s wider evidence of such adverse impacts than when I discussed the issue last month. Consumer confidence has fallen to a 2-year low, employment growth has slowed, UK PMIs have fallen to 3-year lows and corporate borrowing shows signs of weakening. That said, 2016’s rise in UK sovereign CDS premia has retraced and continued flat Gilt-OIS spreads suggest contained fiscal concerns. And the IR seems likely to signal reduced international environment concerns. Neverthless MPC seems likely to trim it’s above-consensus 2016 GDP forecast from 2.2% to around 2%.
• Markets will likely not react significantly to MPC’s inflation projection moving further above target – probably around 2.4% 3-years out – due to the 20-30bp fall in OIS rates, 3% sterling depreciation, and 47% oil price bounce since February outweighing weaker near-term growth. Markets paid little attention to the February IR’s higher 2-3 year inflation projections, Carney’s comments will likely be nuanced (Brexit-driven OIS and GBP moves may ultimately have weaker inflationary impacts) and the IR fan charts will likely be widened.
• So market pricing for the first MPC rate rise not coming until 2019, alongside a 40% chance of a 2016 rate cut, seem unlikely to be significantly affected by Thursday’s MPC communications. Moreover, international factors (ECB TLTRO II, global economic concerns) seem likely to continue being important drivers of gilt yields (cf the recent 0.9 correlation between 10-year gilts and bund yields).
• MPC rate cuts votes seem very unlikely on Thursday. The April minutes signalled cautious reactions to pre-referendum developments and rate cut votes risk adding to the uncertainties i.e. ‘scaring the horses’.
• Indeed, the MPC minutes will likely re-iterate that it’s more likely than not that Bank Rate will need to increase gradually. But they’ll also signal that MPC aren’t in any hurry to do so and will likely amplify that they’re vigilant about the Brexit situation and ready to act if necessary (in addition to already-announced liquidity facilities).
• Sterling’s recent recovery, driven by lower betting market Brexit odds and a ‘risk on’ market environment (see here), seems exposed over the coming weeks (it’s already retraced a little). EU referendum opinion polls have moved less, markets will likely increasingly focus on Brexit uncertainties as the referendum approaches and the risk-on market environment is vulnerable to international developments e.g. the equity rally showing signs of exhaustion.
• Moroever, Sterling has also consistently depreciated (around 0.9%) on recent Inflation Report days, while the UK rates market reaction has been considerably more muted, suggesting bigger FX than rates market action on Thursday.
• While GBP remains vululnerable against EUR and USD, I stick with my view that GBPSEK and GBPJPY short positions likely being more attractive on a multi-month basis (on limited Riksbank and BoJ action plus SEK and JPY undervaluation).
MPC to spell out near-term macro hits from Brexit uncertainties, but cautious interpretation
My previous post highlighted the evidence that Brexit uncertainties were having adverse near-term macro impacts – e.g. reducing firms’ investment and hiring intentions – as well as pulling down on MPC rate hike expectactions and sterling. The April MPC minutes reached similar conclusions. But the evidence of adverse real-side impacts has subsequently grown:
• Actual employment growth has slowed sharply, rising only 20,000 in the three months to February, and the weaker hiring intentions evidence I detailed last month has been supplemented in the latest PMI surveys. While the April minutes noted that MPC expected some employment slowdown the reality has been sharper, albeit only a single observation. But AWE pay growth also declined further in February, with the 1.8% outturn significantly disappointing market expectatons (although flat regular pay growth didn’t disappoint). And XpertHR reports of the weakest median annual pay rises since June 2010 (1.7% in 3-months to April) cautions against expecting a near-term pay bounce despite still-elevated job vacancies.
• UK consumer confidence has fallen to it’s lowest since 2014, as consumers’ optimism about the future general economic situation continued declining (down a notable 20 points from a year ago!). Major purchases intentions have also retraced as consumers have started thinking that now is a good time to save, perhaps reflecting precautionary motives given current elavated uncertainties. Moreover, UK retail sales also signifivantly disappointed in March, although again MPC will be wary of over-interpreting near-term volatility. Nevertheless, the evidence suggests that consumption may well be waning – leading to concerns about sources of growth given the prominent role of consumption (and multi decade-low household savings) underpinnning the UK’s recent unbalanced growth and record current account deficit (see here).
• That concern is amplified by all three UK PMI surveys declining to three-year lows, with Markit arguing that they currently only imply 0.1% q/q growth (from 0.4% in Q1). The services slowdown is most concerning, given that it’s been the main driver of output growth. And Markit observed that “The looming EU referendum has had a profound effect on the sector, keeping prices relatively stagnant and delaying new orders.” Conversely, the manufacturing PMI decline looks like catching up with recent actual weakness in IP/manufacturing production. The weakening of UK PMIs contrasts with the (small) improvement in their Euro Area equivalents.
• While the slowdown in GDP growth in Q1 was expected, it’s broad-based nature across industries suggests that something fundemantal is going. And output growth remains reliant on consumer-facing services – which are vulnerable to weaker consumption.
• Lending to UK corporates (PNFCs) shows tentative signs of stalling, with the BoE credit conditions survey reporting weaker expected demand over the next three months for large firms (the picture is a bit better for medium-sized firms). While the BCC and Deloitte CFO sureys report weakening corporate investment intentions, the latest CBI survey was surprisingly strong.
Consistent with the above, on 28 April Governor Carney acknowledged that “In the very short term the economy appears to be slowing, probably related to issues around the referendum.” Offsetting that, the May IR seems likely to acknowledge that international prospects have improved since February. The Chart above illustrates that real-side data news has improved for both G10 and EM economies – although US data have disappointed in recent months and as have the very latest Chinese data (weaker than expected PMIs), suggesting that it’s too soon to conclude that they are out of the woods (see below).
But the bottom line is that MPC seem likely to cut their 2016 GDP projection on Thurday from the above-consensus 2.2% anticipated in the February IR: around 2% now looks more plausible, with potential downside risks. The 2017 GDP forecast could also be nudged down, depending on how persistent the MPC judges the current slowdown to be i.e. purely Brexit uncertainties versus longer-term challenges from recent unbalanced growth. But the April MPC minutes were clear that MPC are going to be cautious in the pre-referendum period. “Referendum effects were likely to make macroeconomic and financial market indicators harder to interpret over the next few months. As a result, the Committee was likely to react more cautiously to data news over this period than would normally be the case.” So a cut to the 2017 GDP projection would be a significantly more dovish signal. But Carney’s 28 April comment that “Our view is in general the economy is performing pretty well” and the April minutes view that “Developments over the past month had done little to change the broad oulook for activity and inflation” reduce the chances of this occurring.
One further negative development is that UK swap-based 5y5y inflation breakvens have retraced 25bp since early March, hitting their lowest since February 2015 (left hand Chart), despite the sharp oil price bounce (which has seen US 5y5y breakevens rise back) and sterling’s sharp depreciation. And near-term BoE/TNS survey household inflation expectations have fallen to their lowest since 2000 (right hand Chart). But their are some counterveiling facts: (i) UK gilt-based inflation 5y5y breakevens are higher than in February, even if they’ve also fallen in recent weeks; (ii) the more timely EC near-term household inflation expectations survey has recently bounced and medium-term houdehold expectations remain impressively anchored. So overall falling inflation expectations seem more like an amber light for the MPC to watch carefully rather than an immediate pressing concern.
But a further positive is that the 2016 rise in UK sovereign CDS premia I previously discussed has retraced a little (see Chart). Moreover, Gilt-OIS spreads have remained flat since February despite the greater Brexit fears and growth slowdown. So overall market concerns about UK fiscal risks remain contained. Moreover, the ‘canary in the coalmine’ of significant foreign investors net sales of gilts in the three months to February was reversed in March. Rather, foreign net gilt purchases were their strongest in four months in March, thereby significantly improving the 3-month sum picture (see Chart).
Financial Market “conditioning variable” developments imply higher inflation projections, but could be nuanced and IR fan charts likely to be widened
Recent UK financial market developments will, if processed normally (mechanically) by the MPC (BoE forecast team) lead to the inflation projection moving further above target. The Table below illustrates the 20-40bp falls in market MPC rate expectations (see also chart), 3% sterling TWI depreciation and signifucant oil price bounce (up $14.5 bbl or 47%) since the February IR cut-off date the May one (all 15-day averages). And their inflationary impacts should outweigh the disinflationary effects of the weaker activity prospects discussed above. For example, Governor Carney recently detailed how an “exogenous” 10% sterling depreciation raises the MPC’s inflation forecast by 0.75pp per year. So the February IR’s projection that inflation would peak at 2.25% in year 3 seems likely to be revised up: potentially closer to 2.5% but most likely to around 2.4%.
A key issue facing MPC, however, is whether to process the (UK) financial market news mechanically. The fall in OIS rates and GBP depreciation have been importantly driven by Brexit uncertainties – see here plus it’s no coincidence that both OIS rates and GBP have rebounded a little lower betting market Brexit odds. This has several implications:
• As Carney discussed, the the regular mechanical processing of the financial market “news” in the May IR may not be appropriate.
• MPC have rediscovered the important point that the impact of an exchange rate movement on inflation crucially depends on why the FX move occurred. My BoE research and QB Article illustrated this “the source of the shock matters” point, which has recently been explored by MPC member Forbes.
• MPC may therefore chose to ameliorate the inflationary impact of the recent financial market developments, including perhaps more simply because they are not sure that the moves will persist.
• At the least the IR inflation fan charts seem likely to be widened to account for the elevated uncertainties.
Likely limited markets impact from IR and Minutes: dovish at the margin
All of this reduces the chances of market participants taking a hawkish message from inflation being projected to lie further above target. Indeed, markets focussed on the dovish elements of the Feruary IR (weaker near-term inflation projection and potential for second-round impacts on wages) despite projected above-target inflation further out (as I anticipated). This experience, plus the desire to avoid adding to market volatility, mean that Carney’s press conference comments seem unlikely to use push back strongly against very dovish market pricing for BoE policy (which price the first rate MPC hike in mid-2019 and incorporate a 38% chance of a rate cut by end-2016). Indeed, Carney could reference constant (interest) rate inflation projection, which will likely have been revised less than the market rate profile.
So overall, the IR and MPC minutes seem unlikely to have a major rates market impact. At the margin the risks seem slighly skewed to a dovish interpretation – on the weaker growth outlook (see above) and potential further dovish sentences in the minutes e.g. following up Jan Vleighe’s 22 April view that “Theoretically, I think interest rates could go a little bit negative”. But given the April minutes’ comment about reacting cautiously to referendum-affected data I’m not expecting an MPC rate cuts votes on Thursday, although that’s not impossible. But MPC will be reluctant to add to the uncertain climate: a rate cut vote could be counterproductive by ‘scaring the horses’ e.g. by generating ‘what do they know what we don’t?’ questions . Conversely McCafferty is also extremely unlikely to dissent, despite his 20 April clarification that his switch away from rate hike votes was “more one of timing than any root-and-branch change in my thinking“.
So the MPC minutes will likely re-iterate that its “best collective jusdgement is that it was more likely than not that Bank rate would need to increase over forecast period“. But markets will be carefully watching for any dovish changes in language. I suspect that MPC could slightly amplify that they’re vigilantly analysing the Brexit situation and stand ready to act if necessary, in addition to already-announced liquidity facilities. Again the market will likely take a (limited) dovish message.
UK rates remain highly correlated with ones, small reactions to recent Inflation Reports
My view that Thursday’s IR/MPC minutes probably won’t have significant UK rates market impacts also reflects global factors being an imprtant driver. Gilts have fully participated in the recent global bond market rally driven by ECB action (TLTRO II) and global economy concerns, with UK-specific developments often appearing less impactful. At the short end, US developments have been most impactful: the 0.75 correlation between 2-year gilt yields and 2-year US treasury yields (albeit down from above 0.9 earlier in 2016) indicates that the Fed dovishness on global economic concerns has spilt over to UK yields. Conversely, Euro Area developments have had the largest impact at longer tenors. The 0.9 corelation between 10-year gilt yields and 10-year bunds summarises Gilts rallying alongside 10-year Bund yields once again declining towards previous lows over the past fortnight. And that in turn refects a combination of the ECB TLTRO II programme and renewed global economy concerns (see below).
But it’s also notable that the UK rate market reactions to recent Inflation Reports has been fairly muted (see Chart above). UK OIS rates have generally fallen, consistent with the dovish interpretation of MPC communication despite the 2-3 year inflation projections . But the moves were uniformly small – a maximum 1-day impact of 4bp (Novemeber ’15) but more often only 1-2bp. While scale of the the gilt market impacts are a litte larger (maximum 5bp move in 10-year yields) the sign of the moves has been more mixed.
Sterling has depreciated after each of the past four Inflation Reports, recent recovery looks fragile
By contrast, sterling has unifomly depreciated after the past four Inflation Reports. And the falls have been fairly signifucant: the TWI has fallen by around 0.9% on the day’s of the past three IRs, with greater falls occurring against some of the main bilaterals. So GBP seems more likely to weaken if I’m right about the MPC focus on negative referendum-induced activity news and downplaying of upward revision to the 2-3 year inflation projections. Indeed, a version of the pattern around the February IR wouldn’t be surprising.
Moreover, sterling continues to look vulnerable in the run up to the referendum unless ‘remain’ has by then established an apparently unassailable lead.
• I’ve recently detailed how sterling’s 2016 movements have been importantly driven by Brexit concerns and market risk aversion. Sterling’s April recovery reflected lower betting market Brexit odds and better overall risk appetite as concerns about global prospects lessened, the Fed remained dovish and market faith in PBOC increased.
• On top of that, as mentioned above, there’s been a strong correlation between MPC rate expectations (2y OIS rates) and GBP’s moves. Indeed, examining the theoretically-correct UK-foreign relative rates muddies the picture (see second chart).
• But, as I expected, GBP’s April recovery has subsequenty retraced as we’ve moved into May – UK PMIs falling to three-year lows (see above) seems to have been important in generating renewed falls in OIS rates and the GBP depreciation.
And is sterling is vulnerable on several fronts in the run up to the referendum, making further falls likely:
• While betting market Brexit odds have fallen, that improvement has been less apparent in EU referendum opinion polls: while the latter are obviously unloved after the General Election fiasco they could neverthless start getting more attention. Conversely, doubts about Brexit betting markets could grow if financial market participants start questioning who’s driving their movements (underyling voters or larger players who could benefit from any impact on GBP).
• The Scottish referendum experience indicates that, unless the “remain” camp have achieved an apparently unassailable polls lead (unlikely!) markets will likely increasingly focus on Brexit uncertainties as the referendum approaches. For example, 1-month GBP implied volatilities spiked sharply in the run-up to the Scotland vote (see here).
• Market short-GBP positioning, at least amongst the speculative community, has stabilised at moderate levels in recent weeks (see Chart). And the previous experience of other currencies (EUR, JPY) indicates that there’s plenty of room for GBP short positions to extend over the next six weeks if the referendum polls continue to indicate a ‘too close to call’ result.
• The recent risk-on market environment is itself vulnerable – and a move back to risk-off would likely again amplify (unchanged) Brexit conerns and hence be GBP-negative. Indeed, cracks have recently been showing with:
(i) Chinese PMIs recently disappointed (see Chart) and concerns are growing about the credit-bubble being blown by the Chinese authorities’ easing measures (see here and here); (ii) continued weak US activity data – the Atlanta Fed’s GDPNow points to only a limited Q2 bounceback (to 1.7% q/q annualised) after Q1’s weakness;
(iii) conversely, market pricing of a June Fed hike could conceivably rise from it’s very low level (only 4% chance priced!) given recent Fed comments (e.g. Bullard) about it being ‘live’ although Brexit uncertainties add to the case for FOMC standing pat;
(iv) the post-February equity market rally is running out of steam, with all the major equity indices down over the past week (see Chart).
I also disagree with some commentators who’ve been reassured by the recent fall in GBP 3-month implied volatilities i.e. that it indicates that ‘the worst is over’: (i) the retracement has been relatively small and just reflects the 3-month maturity moving out of the eye of the storm as the referendum has moved closer; (ii) 2-month implied volatilities have risen sharply as they’ve entered the eye of the storm (see Chart). So I expect 1-month vols to spike sharply in a couple of weeks time.
It’s also notable that 2-month GBP downside risks (risk reversals) also spiked a couple of weeks ago (see Chart above). Moreover, the risk reversal term structure indicates that option market participants aren’t anticipating a post-referendum GBP bounce: 3-month and 6-month GBP risk reversals are very similar to 2-month ones (see Chart above). By contrast, the median expectation of FX strategists is for post-referendum EURGBP will retracement: to 0.75 in Q4, from just below 0.79 at present. But, more consistent with the options market, FX strategists only anticipate a very limited GBPUSD post-referendum bounce: to 1.46 in Q4 from 1.45 currently.
While GBP remains vululnerable against EUR and USD, I stick with my view that GBPSEK and GBPJPY short positions likely being more attractive. That reflects the combination of likely limited Riksbank and BoJ action, SEK and JPY both being undervalued on a longer-term basis and JPY being an important key beneficiary in a risk-off environment. This week’s Riksbank minutes provided further support likely future Riksbank action tapering – with Floden and Ohlsson facouring QE tapering while Deputy Governor Skingsley advocated stopping QE. Such a divided Riksbank will likely find it hard to agree on further easing, even if the minutes discuss the need to offset “very expansionary monetary policy” elsewhere. That said, the further decline in the Swedish services PMI (the third consecutive fall) poses questions about macro outperformance.