This post previews Thursday’s key MPC policy decision, minutes and Inflation Report, in light of the continued deterioration of UK survey indicators and the MPC’s surprisingly-cautious approach three weeks ago (see here for my arguments for a confidence-boosting risk-management initial 25 cut). Overall, while a 25bp rate cut seems inevitable there’s some danger of MPC’s overall package of measures disappointing the market (£30bn QE extension is already priced) if caution prevails (I hope it doesn’t) which would generate a near-term squeeze of record speculative £ short positions and limited £ strength. Conversely, markets seem to be under-pricing the chances of further rate cuts in September or November. Carney and co have a difficult balancing act.
The main points are:
A 25bp rate cut seems inevitable – markets have finally caught up with my earlier view to now completely price a cut, rate cuts are the MPC’s first line of defence and inaction would damage MPC credibility. Although a 9-0 rate cut vote would usefully boost confidence, 8-1 or 7-2 votes seem more likely (Forbes’ surprising stated wish to see hard data, McCafferty probably maintaining his previous hawkish, Weale following up on his post-PMI volte face). Although unlikely, a narrower vote would probably see UK rates rebound, given likely market inferences about worries about policy efficacy.
Indeed, votes for larger cuts on Thursday shouldn’t be ruled out (Vlieghe, Haldane, possibly Carney), given the need to directly support demand. While actual further cuts will probably have to wait until September or November, OIS markets are under-pricing further action (only a further 8bp fall in priced by November) even if around 0.1% likely represents the lower bound for Bank Rate (given concerns about adverse banking sector impacts).
The precise details of the “various possible packages of measures” alluded to in the July minutes are harder call given that they depend on MPC preferences and precisely how the limited survey data are processed in the forecast. Overall I’m hopeful that MPC will buck recent (ECB, BoJ) trend of dovish expectations being disappointed, given the different UK situation, with at least strong nods towards Haldane’s “sledgehammer” risk-management approach. But there is a risk of disappointment.
- I stick with my view that QE will be extended on Thursday: probably by £50bn initially: a larger initial £75-100bn extension shouldn’t be ruled out given concerns about reduced QE efficacy (less stressed market conditions, apparently weaker impact of ECB PSPP, gilt yields lying substantially lower than prior to QE1/QE2 although Gilt-Bund spreads are currently substantially higher than then).
- But MPC’s July caution also means there’s a reasonable risk of fresh QE being delayed until November, when harder data will be available. In that scenario Carney/MPC will likely want to signal that QE is firmly on the table to forestall the risks of £’s limited recent rise (£/$ up to around 1.33) extending (given that record speculative short GBP positions risk being squeezed) and the gilt yields rising back (global factors recently show some signs of reasserting themselves). Indeed, Carney’s task in the “delay” scenario is made more difficult because some expectation of fresh QE is priced: the mean expectation of £30bn may be a better guide to reactions than the market median expectation of no QE extension.
- A fresh round of QE could be tweaked to exclude ultra-long maturity gilts, to protect pension funds from adverse side-effects. BOE research finds that the largest QE1 impacts were felt on 15-20 year gilts (up to 120bp).
- A larger QE extension could feature corporate bonds, although corporate spreads aren’t elevated and likely weak corporate borrowing demand will limit supply to the already relatively-small market (compared to Gilts).
- A form of forward guidance could easily be re-introduced, mainly aiming to send a reassuring message to households and firms given that financial markets already don’t anticipate a MPC rate rise for nearly 6 years (now after the ECB). The perceived problems with the previous single target (unemployment) guidance mean that MPC could take a leaf out of the ECB’s book and promise to keep rates at the present levels or lower for an extended period of time and and well past the horizon of QE purchases (timing to be spelt out in the QE announcement).
- An immediate FLS extension seems unlikely, given that the main issue is about weak credit demand (backed up by recent survey evidence) not credit supply . But this can’t be ruled out should bank equity weakness continue and/or evidence of adverse impacts of Bank Rate cuts on bank/building society margins accumulate. One option is to cut/eliminate the 0.25% fee currently payable to access the scheme as well as having a more subsidised rate.
- Helicopter money seems off the agenda given the BoJ’s rejection and Carney’s powerful critique that “it puts a hole in its balance sheet … in order for the stimulus to be there it has to hold negative equity forever…you end up in a compounding ponzi scheme“. That said, MPC will likely be made aware of the prospective fiscal policy easing (at least less austerity) in the Autumn statement. The associated extra gilt issuance reduces concerns about BoE running out of Gilts to buy.
MPC’s growth forecasts will inevitably be revised down, and feature significant downside risks, although much depends on how much weight MPC places on the weak surveys. The market consensus estimate is now only 0.5% for 2017, down from 2.2% pre-referendum, with a technical recession at end-2016 looking distinctly possible (PMI data currently point to -0.6% q/q Q3 GDP). The near-term inflation forecasts also seem pretty certain to be revised up to reflect £’s sharp post-referendum fall (£TWI down over 11% from the adjusted May IR assumption), the lower path of OIS rates (2y rates down 25bp) and higher oils prices (brent futures up around $5 at the 27 July cut-off point). The market consensus estimate is now for 2.2% inflation in 2017, up from 1.7% pre-referendum. But the key forecast feature supporting MPC easing is that the inflation forecast should be falling (downward sloping) at the end of the forecast as the price-level effects of £’s fall wane and the effects of the larger output gap are felt.
The mood music in the MPC minutes is likely to be very dovish, with Carney likely stressing the need to communicate that they’re “ready to do whatever is necessary” message to households and businesses as well as financial markets and perhaps stressing the benefits of £’s fall as a useful shock-absorber (although the evidence indicates that the boost to net exports may well disappoint, while household real incomes and hence domestic demand get hit from higher import prices).
While GBP speculative short positions are at record levels, albeit less so as a percent of open interest, £ risk reversals have narrowed relatively sharply and the median FX strategists expectation is for only limited further £ weakness (€/£ of 0.85 and £/$ of 1.27 by end-2016). By contrast, I maintain my view that €/£ will end up closer to 0.90 and £/$ closer to 1.20 as we move into 2017 as UK data (hard) data continue deteriorating, MPC acts more aggressively than the market expects and the market risk environment potentially becomes more challenging.
But there remains a definite near-term risk of a short position squeeze should QE be delayed until November or the MPC rate cut vote be closer than 7-2. Moreover, sterling has proved a little more resilient than I previously anticipated, despite my correctly calling that expectations of MPC easing would grow with progressively poor emerging data. This reflects a combination of: (i) lack of July MPC easing; (ii) some recent $ weakness after the dovish FOMC and poor Q2 GDP data; (iii) the links between £ and policy rate expectations weakening a little, although they still account for over 60% of €/£’s post-referendum moves and up to 50% of £/$’s moves. The latter indicates that dovish MPC policy surprises remain capable of moving £ lower, potentially amplified by greater UK current account concerns should the risk environment deteriorate. My view that the market’s dovish expectations for the ECB and BoJ would end up being disappointed also proved accurate, with the latter helping account for recent equity price wobbles, although my Chinese growth/debt dynamics worries and thought that the FOMC could yet also disappoint very dovish market expectations (only a 57% chance of a Fed hike by end-2017 is priced) remain longer-term burns for now.
The(uncertain) macro backdrop: corporate and household surveys suggest technical recession possible
The highest-profile pieces of bad economic news have been the sharp falls in the UK PMI balances – with the services, manufacturing and construction balances all in contraction territory (below 50) and with the 4.9pts drop in the headline services being the largest ever. And this apparently provoking Martin Weale’s policy easing U-turn (see below). With the PMIs currently indicating to -0.6% Q3 GDP growth (if current levels persist) a technical recession in H2 looks like a real possibility. So Chancellor Hammond’s attempts to downplay the weak PMI data (not “hard activity”) could well come back to haunt him.
Of course, it’s unclear whether the recent large falls represent initial under- or over-reactions. I suspect that the risks are to the downsides as ongoing economic uncertainty, and firms gradually working through the adverse consequences of the Brexit vote will likely trump the small reduction in political uncertainty. That’ll especially be the case if PM May accepts losing single market and potential financial services passporting rights as a price worth paying for avoiding free movement of labour. One other notable thing at the aggregate level was that there seems to have been surprisingly-little adverse spillovers onto the Eurozone as a whole – with the EZ composite PMI holding steady and Draghi apparently in little rush to add to the eaasing measures already in train. Such a picture of the economic damage from the Brexit vote being largely confined to the UK will do little to help the UK’s negotiating position in the forethcoming negatiations (which will hopefully not slip excessively into 2017).
Of course, surveys like the PMIs are inevitably imperfect guides official “hard” activity data (although they in turn are often only more elaborate surveys). But this gets to the heart of the MPC’s dilemma about how much weight to place on the surveys, given that for now they’re the only timely post-referendum data available. One current concern is that the PMI’s didn’t anticipate the upside news in the preliminary GDP release (+0.6% q/q, versus the market’s +0.4% expectation). And the BOE’s Agents survey was more sanguine noting that “As yet, there was no clear evidence of a sharp general slowdown in activity“. That said, firms basically admitted that this reflected them being in the initial stages of working through Brexit’s consequences (there was apparently little contingency planning). And a third of respondents were already anticipating lower hiring and investment. Finally, the Agents’ survey has a smaller sample than the PMI and has been argued to lag it.
The collapse in the PMI headline indices is underpinned by weakness in a worrying number of the components. Composite new orders are now almost two standard deviations below the long-run average – down to 46.1 from 53.0, with the weakest services new business since March 2009 worryingly heading the drop. While services business expectations remained above 50 the drop from the pre-referendum world was precipitous and services employment ground to a halt. The manufacturing PMIs interestingly found that the boost to exports orders from £’s fall was revised down, as firms realised that foreign demand conditions weren’t that hot, and overall orders collapsed despite the boost from £’s fall. That’s consistent with my previous arguments that analysts hoping for a strong boost to UK net exports will likely be disappointed given the disappointing post-2008 depreciation experience. Plus, of course, there’s considerable uncertainties about the UK’s future trading relationships. So the uncertainty-induced slump in domestic demand is going to be hard to offset. Moreover, manufacturers are already finding input prices rising with £’s depreciation, not great for their margins, employment intentions are weak. The Construction PMI weakness revealed broad-based weakness, again attributed to Brexit uncertainties.
I’ve stressed in previous pieces how a major channel via which the highly-uncertain post-referendum environment will have adverse macro impacts is to cause lumpy corporate investment and hiring plans to be cancelled (or at least delayed), entailing weak external financing demand. My previous post discussed how the latest (Q2) BoE Credit Conditions Survey provided some initial evidence of weaker corporate credit demand, but was likely to understate the impact due to it’s timing. The latest Deloitte CFO survey vindicates that feeling – reporting substantial falls in the attractiveness of bond and equity issuance and a smaller fall in the attractiveness of bank borrowing (see Chart). Alongside that CFOs’ M&A and corporate expansion plans have plummeted in the aftermath of the Brexit vote (see chart), as financial uncertainty has risen to around record levels while CFO risk appetite and financial optimism have plummeted.
MPC have been consistently concerned about the state of impact of the Brexit vote on the housing and commercial real estate market – noting the sharp slowdown in the latter even pre-referendum. And on 15 July Chief Economist Haldane noted that “where housing leads, the economy often tends to follow.” So the sharp fall in new buyer enquiries apparent in the RICs survey is not propitious (see chart). And signs of slowing in the London Commercial property market continue growing, although it remains from from meltdown (see Chart). That said,
MPC forecasts: likely to see sharp near-term slowdown and inflation falling back after initial £-driven spike at the crucial 2-3 year forecast horizon.
Given the above, MPC’s growth forecasts will inevitably be revised down, and likely feature significant downside risks, although much depends on how much weight MPC places on the weak surveys. The bottom line is that MPC (and the BoE forecast team) face an almost-unprecedently difficult task given data uncertainties present. But the market consensus estimate is now only 0.5% for 2017, down from 2.2% pre-referendum (see chart), with a technical recession at end-2016 looking distinctly possible (PMI data currently point to -0.6% q/q Q3 GDP).
The near-term inflation forecasts also seem pretty certain to be revised up to reflect £’s sharp post-referendum fall (£TWI down over 11% from the adjusted May IR assumption), the lower path of OIS rates (2y rates down 25bp) and higher oils prices (brent futures up around $5 at the 27 July cut-off point). The market consensus estimate is now for 2.2% inflation in 2017, up from 1.7% pre-referendum (see chart above). But the key forecast feature supporting MPC easing is that the inflation forecast should be falling (downward sloping) at the end of the forecast as the price-level effects of £’s fall wane and the effects of the larger output gap are felt.
Surprising MPC caution in July means that no guarantee of Haldane’s sledgehammer in August
MPC surprised both me an the market by voting 8-1 vote for unchanged rates on 14 July. The market reaction was, however, limited by the dovish MPC minutes signals. Specifically, “most members of the Committee expect monetary policy to be loosened in August. The Committee discussed various easing options and combinations thereof. The exact extent of any additional stimulus measures will be based on the Committee’s updated forecast, and their composition will take account of any interactions with the financial system.”
Andy Haldane’s no change vote was the most surprising: I’d anticipated that he’d join Gertjan Vlieghe in advocating prompt easing, given his previous strong support for risk-management policies. His reluctance reflected data sparsity, on 15 July he argued that “It is still far too early to be drawing strong conclusions on the precise path of the U.K. economy… we have only the smallest trail of data breadcrumbs on which to base any assessment of how companies and consumers are responding to the referendum news.” Such statements caution against presuming that we’ll definitely get a QE extension on Thursday – as I previously argued, we won’t get any “hard” data until mid-August. That said, Haldane also argued that policy easing to support confidence “needs I think to be delivered promptly as well as muscularly. By promptly I mean next month” and that he “would rather run the risk of taking a sledgehammer to crack a nut than taking a miniature rock hammer to tunnel my way out of prison. The MPC does not have that same ‘luxury’ of time.” He also pointed how the signs of a sharp slowdown in construction/housing market activity was a useful bellweather and that did not “think the risk of higher inflation becoming entrenched is especially great.”
Gertjan Vlieghe’s justification for his lone vote for a rate cut in July closely mirrored my case for a 2-staged response, starting in July and built on in August. He also referenced the fragility of inflation breakevens that I highlighted – markets are seeing through the near-term inflation spike from £’s sharp fall and focusing on the impacts of weak demand conditions. Vlieghe also reiterated his view that policy was less stimulative than commonly perceived because the natural rate of interest has fallen due to “Debt deleveraging, changing demographics and a widening of the income distribution across the population…and these factors are likely to persist for years.” So overall there’s a fair chance that Vlieghe could vote for a larger than 25bp rate cut on Thursday, as well as probably voted to expand QE.
Martin Weale’s final few weeks as an MPC member have been turbulent. He first argued on 18 July that he saw little urgency for a rate cut as “The Old Lady of Threadneedle Street is not a nurse to markets” and he gives little weight to “the argument that early action is needed to reassure people.” and “This uncertainty points to the argument that we should wait for firmer evidence before making any policy change,”. He also distanced himeslf from the July minutes comment about the majority of MPC members expecting to ease in August, which was “not in any sense a commitment” given that “We have to be very careful about not cutting interest rates in a way that actually tightens monetary policy rather than eases monetary policy.” But on 26 July he performed an apparent swift U-turn following the weak flash July PMI data “I see things rather differently from what I would have done had we not had those numbers” and more revealingly “if you spend all the time waiting for a clear signal, it never comes.” While Weale didn’t actually say that he’s now vote for a 25bp rate cut, now not doing so would appear like another reputation-damaging U-turn.
Kristen Forbes has been the most hawkish – stressing the potential costs of further easing (on household savings, bank profits, pension & insurance funds, corporate pension schemes, risking higher inflation) and the need to “keep calm and carry on” until more hard data are available. She seems unlikely to have changed her views over the intervening three weeks, given the lack of “hard” data. As an aside, “keep calm and carry on” seems like a good description of prompt MPC aiming to calm the jitters of firms, households and financial market participants in the febrile post-referendum conditions.
Ian McCafferty has kept his cards close to his chest. But given he was until recently the lone MPC member voting to rate increases, he also seems like a good candidate for voting for unchanged policy. So while would likely be confidence benefits from a 9-0 vote for a 25bp rate cut, a 7-2 vote seems more likely.
Governor Carney seems highly likely to vote for at least a 25bp rate cut, given his 30 June comment that ‘The economic outlook has deteriorated and some monetary policy easing will likely be required over the summer.’ and his record of pro-active responses while at the Bank of Canada. I also expect the remaining internal MPC members (Broadbent, Shafik and Cunliffe) to vote for (at least) 25bp rate cuts.
MPC Concerns about reduced efficacy of easing (and potential side effects): can argue for doing more (with QE potentially excluding very long maturities)
I covered the MPC’s continued concerns about taking Bank Rate to around/below zero in my previous post – given the exposure of banking sector margins, particularly building societies reliant on retail funding.
But there’s also a concern that, with rate cuts approaching their limits, a QE extension could well have less bang for it’s buck than during the stressed conditions of QE1 and QE2. That’s not particularly because QE2 was perceived as less effective than QE1 – BOE Staff research (see table below) and recent Martin Weale work suggest the contrary. Rather, it’s the combination of suggest of perceived decreasing efficacy during returns to the Both Kristen Forbes and Martin Weale have recently added to concerns about the efficacy of further QE in the current environment, and highlighted potential negative side effects.
Rather the concerns about efficacy arise from the apparently more limited impacts from the ECB’s PSPP programme (announced January 2015, extended in December 2015 and March 2016) and the BoJ’s QQE programme. While the former may reflect the different structure of the euro area economy, Weale argues that it could also suggest that “with very low interest rates the impact of the policy is weakened … and it would be less effective now than it had been in the past”. More dovish MPC policymakers have, however, previously argued that if a policy risks losing potency the optimal response is to do more of it. The downside, however, is that you also risk scaling up potential adverse impacts of the policy (see below on pension funds). And while it’s obviously true that UK yields are now significantly lower than prior to QE starting (0.8% versus around 5% in mid-2008 as the crisis was unfolding, see chart below) the fall in 10-year bund yields below zero indicates that there could yet be room for Gilt yields to fall further. Indeed, it’s notable that the Gilt-Bund spread has been relatively elevated during the ECB PSPP period relative to the QE1/QE2 period. So optimists would conjecture that such spreads could narrow with an expectation-beating MPC QE extension (as discussed above, the mean expectation is for £30bn to be announced). And they would find some solace in that view from the fact that Gilt-Bund spreads have already narrowed a little in the post-referendum period, as discussions of fresh MPC QE have picked up.
That said, reducing Gilt yields is only the first (required) stage for QE to have macro benefits. Subsequent portfolio rebalancing impacts are also required, which may be less active in the current calmer market conditions (the ma
One specific concerns is the adverse impact of a QE extension on pension funds – reducing ultra-long yields has negative actuarial impacts. Disaggregated BOE research by Daines et al finds that the largest QE1 impacts were felt on 15-20 year gilts (up to 120bp), perhaps because the 20y sector has less “natural” duration buyers. Liquidity managers and bank treasuries like the 5y sector, the 10y sector is the most liquid while pension funds demand 30y-plus gilts in their liability management.
Risk of near-term £ strength on any MPC disappointment, given stretched speculative shorts
Sterling has recentl proved a little more resilient than I previously anticipated, despite my correctly calling that expectations of MPC easing would grow with progressively poor emerging data. This reflects a combination of: (i) lack of July MPC easing; (ii) some recent $ weakness after the dovish FOMC and poor Q2 GDP data; (iii) the links between £ and policy rate expectations weakening a little, although they still account for over 60% of €/£’s post-referendum moves (see Chart) and up 40-50% of £/$’s moves (both down from around 80% in the first three weeks after Brexit see my previous post). The latter indicates that dovish MPC policy surprises remain capable of moving £ lower, potentially amplified by greater UK current account concerns should the risk environment deteriorate.
Risk of MPC disappointing if the surprising caution evident in July carries over into August. Speculative £ shorts are at record levels, so there’s the definite potential for a near-term short-squeeze induced £ bounce should MPC disappoint market expectations. The yen’s recent renewed strength on the BoJ disappointment presents an example.
Option markets and FX strategist consensus is too sanguine on £’s longer-term prospects.
In contrast to the CFTC speculative positioning data, it’s notable that ile GBP speculative short positions are at record levels, albeit less so as a percent of open interest, £ risk reversals have narrowed relatively sharply since the Brexit vote after : the chart below illustrates this for 3-month tenors, but a similar picture is apparent further out.
It’s even more notable that the median FX strategists expectation is for only limited further £ weakness (€/£ of 0.85 and £/$ of 1.27 by end-2016). By contrast, I maintain my view that €/£ will end up closer to 0.90 and £/$ closer to 1.20 as we move into 2017 as UK data (hard) data continue deteriorating, MPC acts more aggressively than the market expects and the market risk environment potentially becomes more challenging.