The policy path before us
Today's news headlines:
- ‘Johnson accused of betrayal as Darroch quits over Trump clash’. Following the leak of diplomatic cables between the UK ambassador to the US and Number 10, the pressure to remove Mr. Darroch has finally had its intended effect. Resigning his position, the former ambassador made it clear that lack of support from the frontrunning candidate for number 10, Boris Johnson, was a determining factor for his exit. (Financial Times)
- ‘Growth slowdown raises possibility of recession’. The latest figures from the Office of National Statistics show a marked slowdown in UK economic growth and may foreshadow an upcoming recession. As ever, the operative question is whether the minor rebound in GDP – following April’s contraction in GDP – was a sign of nascent recovery or just the latest sign post on the way towards stagnation. To add fuel to the fire, the NIESR GDP estimate was also released yesterday, publishing the first contraction since 2013. (Financial Times)
Given that a key motivation for a highly anticipated Fed rate cut is external factors – i.e., trade and political tensions – it stands to reason that these factors would impact other economies as well. The UK’s Bank of England and European Central Bank (ECB) have much less policy headroom than the Fed. The UK has hiked rates a few times for the past few years and the policy rate sits at 0.75%, but that’s a very low setting for late economic cycle. The ECB is in an even more compromised position, with a policy rate at 0 and a -0.40% deposit rate, bringing into the question potential policy options and their ultimate efficacy for either party.
UK MPC member, Silvana Tenreyro, has recently backed away from a potential rate hike in coming months and has instead repeated that policy easing would likely be required under a disorderly Brexit scenario. It’s a subtle shift, but one which suggests the upside potential is fading from the UK outlook. Perhaps more tellingly, the consistent Pound depreciation is widening the current account deficit to nearly 4.2% of GDP, which has been compared to an emerging market currency crisis.
With the departure of Mario Draghi and appointment of like-minded Christine Lagarde, the former IMF Chief, the expectation was that no policy action would occur until her installation. Recent comments from ECB policy members have expressed a readiness to ease policy sooner than that, which could be recognition of the deteriorating outlook. Given the limited scope of potential policy from either the BoE or ECB, the normal prescription would be ‘act early, act aggressively’, but who will act first?
Bottom line: Now that the Fed is set on an easing course, the BoE and ECB will be under greater pressure to act in lock-step. This isn’t purely about the impact of external factors, but also because easing at the Fed means relatively tighter policy settings in the UK and common area, respectively. Yes, the Fed’s easier policy should have an impact on broader, global economic conditions in time, but it isn’t clear that would be enough to salvage the UK and EU domestic dynamics.
Powell cements July rate cut
The Federal Reserve (Fed) is planning to cut interest rates for the first time in a decade due to mounting global growth concerns and weakening domestic data. In his testimony to Congress, Fed Chair Jerome Powell cited weak manufacturing, trade and investment across the globe as the main concerns of the Federal Open Market Committee (FOMC). He carefully avoided being drawn into a political commentary when questioned about Trump’s trade policies, but suggested that the FOMC must consider any factors that may prevent achievement of their inflation and employment mandate.
For the most part, his testimony was geared towards the global instead of the local, but referring to the domestic economy, Powell brushed off the strong headline non-farm payrolls figure for July. When asked whether Friday’s jobs report had changed the outlook for a possible rate cut, he responded with a resounding “no”, stating that “there’s no basis to call this a hot labour market” due to the absence of increased wage growth. As a reaction to the testimony, stocks rose towards all-time highs, gold moved back above $1,400, treasuries climbed, and the Dollar weakened. Markets are now pricing in 32bps of cuts for the July 31st Fed meeting, meaning a cut of 25bps is most likely, with a one-in-four chance of a 50bps cut.
Bottom Line: Given market pricing, a July rate cut was inevitable even before the dovish tone of Powell’s testimony and the minutes from last month’s meeting. Once acknowledged, there is a propensity to factor in ever greater action in subsequent months, but it is simply too soon to draw that conclusion here. This may yet be a stand-alone ‘insurance cut’ rather than the first in a series.
The Fed Chairman’s signal of easing in the July meeting has resulted in an Equity relief rally and Dollar depreciation. Sterling has hardly budged, which means the pair has marginally rebounded.
The Dollar pull back has been a boon to the common currency but only a minor one. The pair itself has moved little. Today, the big events will be a speech from Bank of England Chief, Mark Carney, and release of the European Central Bank’s Monetary Policy Meeting Accounts where we will be looking for signs for a mirroring of the Fed’s dovish policy shift.
Yesterday, the pair rebounded from trade range lows and are making progress this morning. That said, yesterday’s Fed communications were near expectations, so we wouldn’t expect a complete reversal for fortunes.