Markets under-pricing post-Brexit MPC easing: further £ falls as economic weakness trumps recent reduced political uncertainty

This post previews Thursday’s MPC decision and discusses prospects for sterling. The main points are:
(i) markets are under-pricing the chances of MPC rate cuts on Thursday and, especially, in August/November. A full 25bp rate cut is not priced by end-year despite Carney’s strong indication of action during the summer.  Moreover, immediate action would usefully support confidence (i.e. risk management insurance against particularly adverse outcomes), UK prospects were already weakening pre-referendum, post-referendum survey data indicate a relatively-sizeable hit, data uncertainty will persist for months and PM May’s apparent tough stance on free movement of labour implies higher economic costs of Brexit.
(ii) So, despite sparse data, MPC will likely cut Bank Rate by 25bp on Thursday and signal that further cuts are likely in August, probably alongside a £50bn QE extension and a potential extension of the Funding for Lending Scheme.  The chances of the latter two are raised by MPC’s apparent continued reluctance to cut Bank Rate below zero. That said, more hawkish MPC members may prefer to wait to act until the more detailed analysis of the August Inflation Report.
(iii) Overall a moderate UK recession seems like the most likely consequence of Brexit, probably led by a fall in corporate investment and hiring generated by persistent post-Brexit uncertainties but with consumption (the main driver of recent UK growth) also hit by uncertainty effects and the real income fall generated by £’s depreciation. Prompt MPC easing, plus the prospective easing off of fiscal austerity with the likely abandonment of George Osborne’s fiscal targets, can ameliorate the size of the downturn. 
(iv) Sterling’s recent limited recovery (£/$ up to 1.33 from 1.29), generated by Theresa May’s unexpectedly swift PM succession and the more risk-supportive environment, seems likely to reverse once MPC starts surprising on the dovish side. Indeed, UK interest rate moves account for over 80% of £/€ and £/$’s post-referendum fluctuations, MPC seem unlikely to fight £ falls and and financing the UK’s huge current account deficit could potentially become trickier if risk appetite deteriorates (several challenges exist).
(v) So sterling’s recent bounce provides a better entry point for fresh GBP short positions. While sterling’s near-term reaction on Thursday could be limited, depending on the strength of MPC’s dovish signal and market risk appetite, the apparent reduced chances of the UK bidding for Norway-style EEA membership agreement means that £/$ seems more likely to bottom out around/below 1.20 rather than the mid-1.20’s as I previously advocated.  The recent limited negative spillovers of Brexit onto the €, helped by it’s funding currency status and large EA current account surplus, also indicate potentially-smaller constraints on €/£ rising significantly above 0.85 towards 0.90.

Markets under-pricing MPC easing, especially in August/November, MPC to be pro-active despite sparse data

Thursday’s MPC decision on takes place against a background of significant economic and political uncertainty.  My previous post-Brexit piece discussed how markets were under-pricing the likelihood of MPC rate cuts and how sterling seemed likely to weaken further as that mis-pricing was corrected.  While both those predictions have proved accurate, the market still seems to be under-pricing MPC action, despite Governor Carney’s 30 June argument that “In my view, and I am not pre-judging the views of the other independent MPC members, the economic outlook has deteriorated and some monetary policy easing will likely be required over the summer.” In particular, OIS markets are only pricing a 81% chance of a rate cut on Thursday, an 87% chance of one by August and a 90% chance of one by November (up from 40%, 54% and 61% respectively immediately after the Brexit vote). While those probabilities obviously aren’t that far from 100%, the severity of the situation suggest to me that it’s inconceivable that Bank Rate won’t have been cut at least once by August.

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So I stick with my initial view that MPC will adopt a two-stage response – a confidence-boosting 25bp Bank Rate cut on Thursday (with the risks skewed towards larger cuts) followed a further 15-25bp cut in August alongside more detailed analysis, probably accompanied by a £50bn QE extension and/or restarting the Funding for Lending Scheme (although these could slip to September or November). Indeed, that view was supported by Governor Carney’s 30 June comment that “The Committee will make an initial assessment on 14 July, and a full assessment complete with a new forecast will follow in the August Inflation Report. In August, we will also discuss further the range of instruments at our disposal“.  That said, more hawkish MPC members may prefer to wait until the more detailed analysis in the August Inflation Report. 

The obvious difficulty confronting MPC is that data on the (adverse) macroeconomic impacts of Brexit vote are extremely sparse. And that has often engendered a more cautious approach e.g. MPC flagged that they would be interpreting data in the run-up to the referendum with a pinch of salt. But, with the MPC’s previous tail risk of a “materially lower path for growth” having crystalised into the central scenario, several arguments point to a prompt proactive MPC easing:
– there’s a strong argument for an immediate confidence-boosting risk-management 25bp rate cut.
– UK data were already showing significant signs of slowing in the run-up to the Brexit vote.
– timely post-referendum survey data suggest a relatively-sizeable hit.
– the data fog won’t lift until mid-August at the earliest (i.e after the 4 August Inflation Report), scuppering a “wait and see” approach.
– PM May’s apparent tough stance on free movement of labour as part of the Brexit negotiations will raise the UK economic costs.
– MPC can draw on their previous assessment of the adverse economic effects of Brexit: they can rely on what their models are telling them, although parameter (Brainard) could conceivably come into play.

Taking each in more detail.

First, there’s a strong risk-management argument for immediate MPC action given the regime change engendered by the Brexit vote: the cost of inaction likely far outweigh any potential downsides of prompt action (it’s highly unlikely to have to be reversed quickly). In other words it’s worthwhile MPC easing promptly and aggressively as insurance against particularly adverse outcomes. The aim of prompt action is to support consumer, business and financial market confidence and try and ameliorate the inevitable rise in Brexit-driven uncertainty.  That objective has thus far underpinned the BoE’s very pro-active approach (stressing their preparedness to act and banking sector support) and so should be expected to continue on Thursday. More technically, the aim is to reduce the option value of households/firms waiting, thereby cutting the hit suffered by large, lumpy and costly-to-reverse decisions about durables consumption, job hiring and capital investment. Governor Carney argued on 30 June that “there is growing evidence that uncertainty about the referendum has delayed major economic decisions, such as business investment, construction and housing market activity.” And I anticipate such negative news to continue in subsequent surveys: the 24 July special ‘flash’ UK  PMI release will be carefully watched.

Indeed, confidence could well be undermined were MPC to stand pat on Thursday, given Carney’s 30 June strong indication of easing over the summer, although likely dovish signals in the minutes would ameliorate the impacts. In particular, the recent equity price bounce driven by growing policy easing expectations would be vulnerable to a disappointment.  Here it’s notable that the UK-focused FTSE 250 index has recovered significantly less than the FTSE 100 (see chart), which has been supported by sterling’s depreciation raising the value of foreign earnings.  And while UK bank equity prices have also recovered  a little, they remain 20-30% below their pre-referendum levels  (second chart below).  While the recent FSR argued that UK Banks are in a fundamentally-stronger position than during the financial crisis, and the FPC cut the Countercyclical Capital Buffer from 0.5% to zero (and extended the ILTR’s) to support  lending capacity, MPC would probably want to avoid unnecessary volatility by disappointing easing expectations.

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Second, UK data were already showing significant signs of slowing in the run-up to the Brexit vote: GDP growth has slowed from around 0.8% q/q in 2014 to only 0.4% in Q1 2016. My April piece correctly anticipated heightened MPC concerns. And I discussed here how, given continuing high household debt and low household savings rates (see Chart), the continued reliance of UK growth on consumption looked vulnerable.  On 5 July Governor Carney noted that “the number of vulnerable households could increase due to a tougher economic outlook and a potential tightening of credit conditions.”  Moreover, UK households are set to suffer a real income hit from the rise in import prices (and hence CPI inflation) associated with sterling’s sharp depreciation, reinforcing the negative of confidence impacts of persistent uncertainty about the post-Brexit regime.  But the larger impact of Brexit uncertainties will likely be felt by the UK corporate sector, via reduced investment expenditure and hiring. And the pre-Brexit June PMIs paint a worrying picture, suggesting Q2 GDP growth of only 0.2%, with: (i) the services PMI figure falling to the lowest since April 2013; (ii) services business expectations plunging to their lowest since December 2012 (66.4 versus 70.8 in May); (iii) the weakest services employment since August 2013; (iv) the construction PMI falling into outright contraction territory and a 7-year low; (v) the weakest construction new work since December 2012. The exposure of the dominant service sector to a poor post-Brexit deal, including financial services firms relocating if EU passporting rights aren’t maintained and if clearing of Eurozone derivative trades relocates away from London, is also a major concern.

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Third, timely post-referendum survey data suggest a relatively-sizeable hit, consistent with the UK economy slowing sharply, indeed potentially falling into a (moderate) recession led by weaker investment generated by heightened uncertainty but with consumption also being hit by falling consumer confidence and reduced real incomes (higher import prices, given £’s depreciation).

  • A 24-26 June Institute of Directors survey reported 64% of respondents thinking that Brexit is negative for their business (37% very negative), 24% planning to freeze recruitment (5% making redundancies), 36% planning to cut investment (19% significantly) and 22% are considering moving some of their operations outside of the UK.  Such (consistent with the decline in investment intentions in the BoE Agents survey I discussed here).
  • The Lloyds Bank commercial business confidence barometer fell to it’s lowest since Dec 2011 after the Brexit vote (+6 in 24-29 June compared to +32 in May).  Similarly, the weekly YouGov/CEBR business optimism survey also reported a sharp post-referendum fall,  with 49% pessimistic about 12-month economic prospects (versus 25% pre-referendum) and 26% pessimistc about their own business outlook (versus 16% pre-referendum).
  • A 30 June-5 July GfK survey reported consumer confidence falling sharply, to it’s lowest since December 2013 (see Chart below) and the weekly YouGov CEBR consumer confidence series declined to it’s lowest since May 2013 immediately after the Brexit vote. While the headline GfK figure remained above the series average (-9 versus -1 in June), that was helped by “leave” voters being more optimistic than “remain” voters (-5 and -13 respectively).  And  consumers’confidence about the general economic situation plummeted to it’s lowest since December 2012 (-29, down a stunning 42 points since June 2014) to lie not that far above the post-financial crisis low (-41 in December 2011).  While the fall in the major purchases intentions balance was less marked, the dip below zero nevertheless argues that durables consumption, which is most vulnerable to elevated uncertainty, could well suffer a post-referendum hit. Some support to consumer confidence (and the housing market can be provided by the continued edging down of mortgage rates (see chart) i.e. a de facto easing of conditions. But the hit to household’s real incomes from the higher import prices following £’s depreciation will further depress consumption (with the household savings rate already looking unsustainably low).
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  • The latest BoE Credit Conditions survey reports weak expected credit demand in Q3, especially amongst medium-sized companies but with household secured credit demand also continuing to decline (see Chart). Moreover, banks anticipate weak corporate credit demand to fund M&A activities, capital investment and real estate activities (see chart, with Banks also anticipating tightening credit supply to real estate).  So Governor Carney’s scenario that “if we do see a slowing in credit growth, it will be demand driven not supply driven” could eventuate.  Indeed, these data likely understate the potential for lower credit demand because most of the survey sample period predates the Brexit vote (BoE are less precise than usual on the dates, simply noting that it runs to end-June).

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Fourth, the data fog won’t lift for a number of months, rendering a “wait and see” approach redundant.  In particular, none of the high-profile official ONS data series will include post-referendum outcomes until mid-August i.e after the 4 August Inflation Report. Rather the main pieces of extra information will be in surveys: in addition to the previously-discussed 22 July ‘flash’ PMI release, the 20 July BoE Agents report and 18 July CFO survey (which showed very worrying signs in Q1, see here) will be among the closely-scrutinised releases. Overall, I continue to expect them to paint a negative picture – although it’s unclear whether the negative impacts will be apparent immediately or take a couple of months to emerge (given that they appear unprepared for Brexit and hence will have to do some serious planning, which could initially appear as ‘business as usual’).

Fifth, PM May’s apparent tough stance on curtailing free movement of labour as part of the Brexit negotiations (“Brexit means Brexit”) will likely raises the UK economic costs. Angela Merkel and other EU leaders have repeatedly stated that free movement of labour is a precondition of access to the single market, importantly including UK financial institutions keeping their EU passporting rights.  This apparent ruling out of a Norway-style EEA membership deal again argues for a strong initial MPC response (and consequent £ weakness).

MPC still think that the lower bound applies: QE and FLS likely to come into play  

That said, MPC’s previous aversion to cutting Bank Rates below zero, given the adverse impacts on lenders’ margins (especially building societies reliant on retail funding) seems likely to continue. Specifically, on 30 June Governor Carney argued that “As we have seen elsewhere, if interest rates are too low (or negative), the hit to bank profitability could perversely reduce credit availability or even increase its overall price.” And in April Gertjan Vlieghe, probably the most dovish MPC member, noted that low rates could provoke households and companies to start stockpiling cash rather than using bank accounts: “I think the switching point is somewhere around minus 0.5%, minus 0.75%, maybe minus 1%. But I’m also saying I don’t even want to get close to it because I don’t know exactly where it is.

The corollary of such (understandable) MPC reluctance to follow the ECB, BoJ, SNB and Riksbank by taking Bank Rate into negative territory is a higher probability of a QE extension and/or the Funding for Lending Scheme being extended (although the FPC’s cutting of the Counter Capital Buffer and the extension of the Bank’s ILTR’s until end-September reduce the chances of FLS action).

Recent Sterling rally on new PM to unwind on MPC easing and potential current account worries 

My previous post argued that the extreme post-referendum political uncertainty had the potential to amplify asset price movements. But, in a rare piece of good news, the quick succession of Theresa May as UK PM ameliorates such concerns (someone is finally “in charge”).  Markets also seem to have been reassured by May’s comment that she didn’t anticipate triggering Article 50 until 2017 and hope that she’ll adopt a more flexible negotiating position than Andrea Leadsome.  I’m not convinced on either count.  While it’s obviously essential to have a coherent Brexit plan, taking months to formulate it will only prolong the uncertainty facing UK households and firms, with consequent greater economic costs.  So any retracement of the recent unprecedented rise in the UK policyuncertainty.com measure, which has spilled over onto the Euro Area (see Chart), may be limited.  And, as discussed above, PM May’s “Brexit means Brexit” stance doesn’t suggest much negotiating flexibility i.e. a Norway-style EEA membership outcome looks off the table, with consequent higher economic costs.

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Nevertheless May’s swift succession, alongside generally improved market risk appetite (also helped by Japanese PM Abe’s election win) has been associated with a mini sterling recovery this week. Specifically, £/$ has risen from 1.29 to around 1.33, while the bounce in the risk-sensitive £/¥ has unsurprisingly been larger (see Chart above). Indeed, the chart below illustrates that £/¥ has recently moved relatively closely with UK equity prices – particularly of large UK banks rather than the domestically-focused FTSE 250. That’s consistent with a “risk-on” narrative where the S&P 500 has also touched record highs, while safe haven government bond yields have also a little above their record lows.

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But that sterling bounce seems likely to be short-lived for several reasons: (i) MPC easing dovishly exceeding market expectations will provide fresh impetus to sterling weakness, especially since UK interest rates have accounted for close to 80% of sterling’s post-referendum moves (see below); (ii) MPC seem likely to view sterling falls as a helpful part of the necessary adjustment process rather than worrying about inflation pressures and consequent real income hits; (iii) recent risk-on market conditions appear vulnerable; (iv) UK current account funding concerns could yet re-surface.  So overall the sterling’s recent bounce provides a better entry point for fresh GBP short positions.

As discussed above, MPC easing seems likely to exceed market expectations over the coming months – starting with a 25bp rate cut on Thursday that is only 80% priced and likely signalling further action in August. And that will likely start a fresh leg of sterling weakness, as market MPC views continue adjusting in a more dovish direction.

It’s also notable that while £/¥ has very recently been a little stronger than implied by market interest rate developments, the £/€ and £/$ bilaterals have remained very tightly linked with UK interest rate movement.  Specifically, the two charts below illustrate that 10-year gilt yield moves account for over 80% of £/€ and £/$ moves, with those R2 statistics exceeding the already-high pre-referendum explanatory power and with slope coefficients little changed from the pre-referendum period. While obviously based on a small sample, these results are nevertheless striking: despite all the Brexit-induced turbulence previous relationships have held and indeed strengthened, indicating that thus far sterling assets haven’t attracted substantial risk premia. The implication is that sterling should continue closely tracking interest rate moves going forward – if risk premia haven’t significantly arisen at the height of the storm, they seem less likely yo do so going forward (I discussed here how this probably reflected the better position of UK banks compared to the financial crisis, as stressed by the BoE Financial Stability Report). So underpriced MPC rate cuts (and QE extensions) will likely to generate further sterling weakness.

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The initially-surprising thing here is that it’s UK rates per se that are most closely linked with £’s moves, rather than the UK-foreign interest rate differential suggested by textbooks: the table below indicates that the regresion R2‘s are higher in all but two cases in the post-referendum period.  But I previously discussed how this reflects Gilt yields’ extremely high correlation  with Bunds and US Treasuries, likely driven by global growth/inflation concerns. And while the 10-year Gilt yields have the highest explanatory power, it’s also notable that the R2‘s for 2-year OIS rates have also remained surprisingly high, around 70%, over the post-referendum period.  And such rates should fall further on a more dovish than expected MPC, hence generating further sterling weakness. The final thing to note is that the R2‘s for £/¥  are universally smaller, plausibly indicating a greater role of risk aversion (safe haven effects) and hence the previously-discussed links with (bank) equity prices.

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Further sterling weakness also seems likely given that MPC seem more likely to view sterling’s post-referendum tumble as a helpful part of the adjustment to the new post-referendum reality.  So MPC seem unlikely to try and fight it because of concerns about the upwards pressure on inflation and consequent hit to consumers’ real incomes. Specifically on 5 July Governor Carney argued that sterling’s fall  “likely adjustment has moved in the direction that is necessary to facilitate some of the economic adjustments that are going to be required in the economy.” That’s consistent with my previous argument that MPC would likely look through the temporary inflation impacts of sterling’s fall and instead concentrate on the wider output gap generated by weaker demand (with supply fixed near-term).  Indeed, the temporary inflationary boost from sterling’s fall should be welcomed given recent persistent inflation undershoots: even core CPI hasn’t been at target since Q3 2013. And that should helpfully ward off the risk of inflation expectations de-anchoring: indeed 5y5y inflation breakevens show recent signs of fragility (see chart above).  That said, MPC show signs of re-learning my long-standing argument that the inflationary implications of a £ depreciation depend on why it has occurred (see Kristen Forbes’ recent paper).

The UK’s huge 6.9% of GDP current account deficit also represents a Sword of Damocles hanging over sterling, especially in a UK recession scenario, via several channels.  While sterling’s depreciation will increase the sterling value of foreign-currency denominated primary income receipts, Brexit-related effects could potentially lead to the trade deficit widening, despite sterling’s depreciation. The relatively-weak response of exports to sterling’s 2008/9 depreciation, which was proportionally smaller than both the 1992 depreciation and the 1996 appreciation (see chart) as exporters raised profit margins, indicates that Governor Carney risks being over-optimistic in arguing that “More positively, sterling’s sharp depreciation should, for given foreign demand, provide support to UK exporters.” Carney did, however, also acknowledge that “this may well be dampened by uncertainty around future trading relationships” in line with the general lesson that foreign demand conditions are more important determinants of UK next exports than £ moements. Moreover, the 4.7% of GDP services trade surplus, which partly offsets the 7.2% of GDP goods trade deficit (see Chart) could be particularly vulnerable: getting a EU trade deal on services is likely to be tougher than for goods and UK banks risk losing their EU passporting rights (hitting financial services exports, which make up a third of the services trade surplus).  And the hope that the recent weakness in FDI income, which turned negative in Q4 and Q1 , will reverse as Euro Area growth improves could be dashed if Brexit has adverse spillover effects onto the EA (via trade, confidence and financial channels).

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A prolonged period of elevated uncertainty could also lead to a rise in the risk premium required on UK assets and/or cause foreign investors to become more reluctant to invest in UK assets i.e. provoke capital outflows.  Indeed, the recent BoE Financial Stability Review reported that data non-residents sold 0.7% of GDP worth of FTSE 100 shares (see Chart above).  While that’s not yet anything particularly dramatic, it’s nevertheless a straw in the wind that needs to be watched, especially in a high uncertainty environment.

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Indeed, recent improved market risk appetite, driven by expectations more dovish global central banks, could prove fragile in the coming months thereby potentially amplifying £ weakness (especially £/¥).  First, UK and Euro Area data could well turn out worse than currently expected, especially if confidence is damaged by the protracted uncertainty about the eventual Brexit deal. Second, the ECB, Fed and BoJ could prove less dovish than anticipated. The ECB risks reaching the limits of its toolkit – I’m not expecting any strong ECB easing signals at their 21 July meeting, despite press reports of PSPP tweaks to deal with difficulties purchasing Bunds – and several Governing Council members have cautioned against expectations of further easing (Brexit effects won’t be incorporated into ECB forecasts until September, when they’ll also include TLTRO2 and CSPP programme effects).  While markets have become increasingly dovish about Fed policy in the wake of Brexit (the first hike ins’t priced until 2018), several FOMC members have argued that Brexit has very limited direct (i.e. trade) impacts.  So should the FOMC’s concern about a potential tightening of US financial conditions not eventuate the improvement in US data could well being a 2016 Fed rate rise back onto the agenda.  Third, markets could again start to be concerned about the efficacy of monetary policy (returning to the theme apparent in Q1) e.g. on 30 June Governor Carney argued that “one uncomfortable truth is that there are limits to what the Bank of England can do.”  Fourth, Chinese worries could yet resurface: (i) PBOC is treading a tightrope with it’s FX policy -(see Chart above) – markets could yet start being concerned about the gradual Yuan depreciation should Chinese FX reserves start falling again; (ii) the further rises in the Chinese debt mountain generated by the previous stimulus, which now seems to have provided a near-term growth boost, could start worrying markets.

There are, however, some limited positives.  First, the recent huge UK current account deficits have been financed by the “stickier” sources of FDI and portfolio investment (see Chart), although this could well become more challenging in the post-Brexit world e.g. with the UK becoming a substantially less attractive destination for FDI aiming to access the single market (car manufacturers etc).  Second, positive revaluation effects mean that the persistent current account deficits have not translated into a deterioration of the UK’s net foreign asset (international investment) position – indeed this position narrowed to only -6.7% of annualised GDP in Q1, compared to around -19% in 2014 Q3 (see Chart).  Moreover, the currency composition of UK assets and liabilities means that the UK net foreign asset position actually improves when sterling depreciates (see my BoE Quarterly Bulletin article): the UK international balance sheet does not suffer from “wrong way” risk. That said, FX market participants typically pay little attention to such international investment position data, so it will likely not inhibit further £ falls.

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