Mixed data shelters BoE from policy action
Today's news headlines:
- ‘India raises US tariffs after losing trade access’ The Indian government retaliated over the weekend to the recent US dropping of preferential trade terms for India, by placing tariffs on US goods effective from 16th June. Only time will tell as to whether this may be a new front to the global trade war or the start of serious negotiations.
- ‘Bond markets unconvinced how effective Fed tools are’ The simultaneous appreciation of both bond and equities markets, is unusual in a historical context. It also suggests markets have an inconsistent view about inflation dynamics, which acts in opposing ways on these asset classes. (Financial Times)
Mixed data shelters BoE from policy action
The UK’s sub-par GDP growth figure for April has given the Bank of England’s (BoE) monetary policy committee (MPC) breathing space to keep interest rates on hold, for now.
In their May inflation report, the MPC saw output rising 0.2% for the second quarter. However, realised output for April fell by 0.4%, due to the unwinding of Brexit stockpiling and car factory shutdowns. While the BoE is likely to downgrade growth expectations for Q2, citing weakness as temporary, they are likely to provide a balanced statement; highlighting potential global growth concerns on the one hand, but the case for a rate hike if Brexit were to be resolved on the other.
The labour side of the economy, defined by employment and wage growth, is very strong which argues for a hawkish BoE stance. However, Brexit headlines define the timeline of its manifestation. The MPC assumes a smooth and orderly exit in all its forecasting, which looks increasingly unlikely, so the market may be proved wrong.
Bottom Line: Many of the candidates vying to replace Theresa May as Prime Minister are willing to take the UK out of the EU without a deal. In this scenario, the BoE would almost certainly have to loosen policy instead. The prospect of an abrupt policy change in reaction to Brexit outcomes might diminish the MPC’s credibility, so the ‘wait and see’ approach is the only policy on offer right now.
Confidence is King
Continued global trade tensions and slowing global economic growth has resulted in a dovish policy stance among the world’s central banks. This morning, European Central Bank (ECB) member, Benoit Coeure, suggested the central bank is ready to act within months, raising the prospect of rate cuts and continued QE.
Later today, Head of ECB, Mario Draghi will speak and have an opportunity to qualify his colleagues view. Looking at the policy tools at their disposal, when the interest rate is already at 0% the efficacy of rate cuts is unclear. In a negative interest rate environment, rate cuts become less effective. While lower rates do make it more attractive for the borrower, it reduces bank lending profitably, in large part offsetting the policy objective. What’s more, the ECB is already near its self-imposed limit on QE. While these limits can be changed, the central bank will eventually have to unwind their balance sheet and may be reluctant to engage in further purchases when the policy effectiveness is marginal. Cheap bank loans have been already been announced, although details released last month disappointed investors with lacklustre loan conditions.
While the ECB is confident they can use their arsenal to support the weakening Euro-area, markets remain sceptical. Inflation expectations and bond yields have hit alarming lows and the common currency has pulled back from a short-lived rally at the beginning of June damaging hopes of a sustained Euro appreciation.
Bottom Line: Draghi is hoping to boost investor confidence and support the ECB’s credibility as his term as President comes to an end. With slowing growth and low expected inflation, the central bank is ready to act within months and has a range of policy tools at their disposal. However, the effectiveness of any policy intervention is questionable. The Euro looks unlikely to pull out of its trading range unless confidence in the Eurozone can be lifted.
The trade-weighted Dollar rallied convincingly on Friday and now sits above the 50-day moving average. After a week of consolidation, the Pound resumed its gradual downward journey. The pair is sitting near the bottom of the current trading range with about a cent remaining until we hit the December 2018 lows.
The Dollar’s rally resulted in an unwinding of EUR gains from the beginning of the month. While the common currency seems supported at the trade weighted 100-day moving average, the Dollar is metaphorically in the driver seat. The ECB speeches today and tomorrow have the potential to change the story, though no substantive action is expected.
Little has happened to this pair in preceding days, largely because EUR depreciation has matched Pound depreciation. As both the Bank of England and the European Central Bank policies proscriptions are hobbled by waning global growth expectations, sentiment needs to improve to return volatility to this pair.