Central banking double bill

Today’s news headlines:

  • 'US Proposing new round of trade talks with China'. Some Trump officials said they sense a new vulnerability and possibly more flexibility among Chinese officials. (Wall Street Journal)
  • 'Canada sees more NAFTA talks this week, much work remains: source' (Reuters)
  • 'EU sees shift on Irish border as Brexit rebels plot'. EU sees UK concessions on Irish border after Tory conference, but pro-Brexit Conservatives may consider ousting May. (Bloomberg)
  • 'Britain will not pay Brexit divorce bill if there is no deal, Dominic Rabb warns Brussels'. (Telegraph)
  • 'Theresa May toughens up immigration rules to counter Tory rebellion'. Theresa May wants to announce strict immigration controls at the Tory party conference to reassure Brexiteers and steady her leadership in the face of an open revolt. (The Times)

In Wednesday’s trading, the Pound to US Dollar (GBP/USD) exchange rate moved below the now symbolic 1.30 level, on news reports that Eurosceptic MP’s within the ruling Conservative Party were considering a leadership challenge to replace Prime Minister Theresa May. GBP/USD managed to regain the 1.30 handle on more constructive Brexit headlines, but a leadership challenge is the biggest risk to our base case of an orderly soft Brexit. An orderly outcome has looked increasingly likely in recent days due to the EU’s more conciliatory tone.

For a leadership challenge, Tory MPs need to trigger a confidence vote, brought about once 48 Conservative MPs write a letter to the Chairman of the 1922 Committee. They have the numbers. There are reportedly 70 members in the anti-EU wing of the Tories, the European Reform Group.

There are two options as to why they haven’t yet sought a leadership challenge. First, Conservative Party rules state that if a Prime Minister wins a no confidence vote, via a simple majority, another cannot arise for 12 months. Therefore, the Eurosceptic Tories may be biding their time until May is at her weakest.

The second option is pragmatism. These are career politicians; they know May’s Brexit proposal is the best compromise between concerns voiced at the EU referendum and what is acceptable to the EU. On Tuesday, Eurosceptic MPs abandoned plans to publish their own Brexit proposal, after being challenged by Theresa May to come up with an alternative. The Brexiteers are looking towards the May 2020 general election; they know it’s easier to sell a counterfactual hard Brexit and ridicule May’s soft approach, than defend a hard Brexit they implemented and its consequences.

The Eurozone’s July Industrial Production number marked a soft start to Q3 and mirrored weakness in Germany’s industrial output measure. The recent weakness in economic data heightens the risk that the European Central Bank (ECB) downgrades its economic forecasts in Thursday’s meeting. A headline to this effect pressured the common currency lower during yesterday’s morning session, suggesting an economic downgrade is now expected.

For the day ahead, Europe steals the spotlight with its two biggest central banks announcing their rate decisions. The Bank of England (BoE) is in the dark along with the rest of the business community on a potential Brexit deal. With a no-deal Brexit a possibility, the BoE is likely to ignore all its traditional indicators that are flashing red – the UK is hitting its supply capacity and risks overheating – and keep policy unchanged. The risks to Sterling are to the upside with the market pricing in only a 55% chance of a rate hike in the next year and market short Sterling bets extended.

Predictable but not pre-committed will be the mantra of the ECB’s policy decision Thursday. The ECB will likely maintain its guidance that interest rates will remain at current levels until the end of summer 2019. Economic projections are likely to be slightly downgraded, though; by now this is largely expected. The focus instead will be on the end of net asset purchases; specifically the word ‘anticipates’. We believe the ECB will maintain that it ‘anticipates’ slowing the pace of net asset purchases after September before bringing them to an end in December. The inclusion of ‘anticipates’ emphasises the ECB’s prerogative to change its mind.

Downside risks to the Eurozone have risen meaning the ECB will want to maintain flexibility. The German economic engine is sputtering under the impact of the US trade war. Italian politics remain a market concern. Will Italian yields spike without the ECB’s bond purchases? A stronger trade-weighted currency and Brexit add to the pile of risks. The Eurozone still lacks a common bond market meaning asset purchases are tangled up in politics. The stack of risks and the ECB’s limited ammunition are behind our call that policymakers will disappoint markets and delay policy normalisation.