The Bank of England meets Thursday. It is widely expected to increase its asset purchases by GBP100 bln. The bank is navigating tricky waters between the pandemic impact and Brexit negotiation, but all arrows still point to more easing with risks of a dovish surprise. Below is a list of what we see as the potential actions it can take.
WHAT ELSE CAN THE BOE DO?
At the May 7 meeting, the BOE delivered a dovish hold. The vote to hold rates was 7-2, with the two dissents (external members Saunders and Haskel) in favor of an immediate GBP100 bln increase in its asset purchases. External member Tenreyro, Governor Bailey, Deputy Governor Broadbent, and Chief Economist Haldane have since weighed in on the need for further stimulus, so that pretty much settles it. But beyond QE, there are several other moves that the BOE could make this week in the coming months if needed.
1. Tweak existing asset purchase programs – LIKELY NOW, LIKELY AGAIN IN H2. Consensus sees a GBP100 bln increase but we think there are risks of an even larger number. At its May meeting, the BOE estimated that the GBP645 bln limit would be reached by early July. With budget deficits and gilt issuance still rising, why not get ahead of the curve with an even larger QE increase? The bank could also explicitly change the mix of debt to be purchased and could also widen the types of securities it will buy, as the Fed has already done. Recall that the bank boosted its asset purchase program by GBP200 bln on March 19 to GBP635 bln, with that increase to be divided between mostly government bonds and some corporate bonds.
2. Tweak its lending programs – POSSIBLE NOW, LIKELY IN H2. The BOE introduced a new Term Funding Scheme with additional incentives for small- and medium-sized enterprise (TFSME) on March 11, when it also cut the bank rate 50 bp to 0.25%. The scheme provided 4-year funding at a rate close to the newly lowered bank rate. The amounts were limited to 5% of total lending, but additional funding is available to banks that boost loans to small- and medium-sized enterprises. Both the rates and the limits could be adjusted to provide more lending.
3. Tweak its forward guidance – UNLIKELY NOW, POSSIBLE IN H2. At its most recent meeting, the BOE said that “The MPC will continue to monitor the situation closely and, consistent with its remit, stands ready to take further action as necessary to support the economy and ensure a sustained return of inflation to the 2% target.” The Fed seems to be putting more emphasis now on fulfilling its full employment mandate and so perhaps the BOE will follow this path and insert some language regarding unemployment.
4. Introduce Yield Curve Control – UNLIKELY NOW, POSSIBLE IN H2. Much of the BOE’s attention appears to be on negative rates, though officials stress that all options are being studied. We think the main reason why Yield Curve Control (YCC) isn’t in the central bank’s public dialogue yet that the market is already doing the heavy lifting for it. The 2- to 4-year portion of the UK curve is currently in negative territory, while the short end and middle of the curve out to 8-years are yielding less than 10 bp. Furthermore, the 10-year yield is currently around 23 bp, which is near the lows of the cycle. This means the UK gilt curve remains very low and very flat, which is exactly what YCC would achieve. If perceived improvements in the UK economy push UK yields significantly higher, then we think YCC becomes more likely. It’s worth noting that continued BOE talk of negative rates (see below) is likely contributing to low UK rates across the curve.
5. Negative interest rates – VERY UNLIKELY AT ANY TIME. BOE officials seem to be spending a lot of time discussing negative rates. Cunliffe, Bailey, Haldane, Ramsden, and Tenreyro have all said that negative rates cannot be ruled out. The bank could still cut rates 10 bp to zero, but we do not believe the UK economy is built to withstand negative rates. Why not? The financial sector is a large part of the UK economy. This sector is already at risk from the prospects of a hard Brexit, and so the last thing it needs is negative rates that would further harm profitability and distort lending and borrowing incentives. Some analysts are calling for negative rates in the case of a hard Brexit, but we think such a move would simply compound the problem for UK banks.
Prime Minister told consumers to “shop” with confidence as the UK reopens. Stores reopened Monday and Johnson said that social distancing requirements of 2 meters may be relaxed as infection rates fall. This is a growing source of tension between Johnson and UK health officials, with chief medical officer Whitty saying the 2-meter rule will need to stay in place for months still. Chancellor Sunak said Johnson was launching a “comprehensive review” of the social-distancing measure, which he noted has “an enormous impact” on the profitability of businesses. Business Minister Scully said the review would take “a matter of weeks.”
UK GDP contracted by a whopping -20.4% m/m in April, worse than the -18.7% expected. The three month-on-three-month rate came in at -10.4%. All areas were hit hard, except for government spending, of course. In addition, IP and manufacturing production contracted -24.4% and -28.5% y/y, both considerably worse than expected. Construction output was also worse than expected at -40.1% m/m and -44.0% y/y. The worst of the pandemic impact was probably over in May, but the UK recovery could prove slower than in other places given the relatively greater virus numbers it has experienced.
UK’s GDP is forecast by the IMF to contract -6.5% in 2020, followed by 4% growth in 2021. The BoE is more pessimistic for this year as it forecasts -14% contraction. However, growth is forecast at 15% in 2021. Lastly, the OECD now sees -11.5% contraction in 2020 followed by 9% growth in 2021. Brexit adds to the uncertainty for 2021, as the optimistic bounce-back scenario is unlikely to materialize if there is a hard Brexit. Q1 GDP contracted -2.0% q/q and -1.6% y/y, slightly better than expected but still weak. With the lockdown only now beginning to be lifted, Q2 is likely to show further contraction, with Blomberg consensus currently at -16.8% q/q and -15.4% y/y. Consensus sees 10.5% q/q growth in Q3, but that clearly depends on how the reopening progresses.
Poor fundamentals and ongoing Brexit risks have kept sterling underperforming this year. So far in 2020, sterling is -4.6% and ahead of only the worst performing major NOK at -7.6%. After trading last week at the highest level since March 12 near $1.2815, cable gave back some of those gains due to risk-off sentiment. Now, with risk sentiment improving and both the UK and EU softening their Brexit tone, sterling is bid again. It is testing the 200-day moving average near $1.27 currently. Break above that would target last week’s high near $1.2815. The $1.30 level serves as a round number target and after that is the March 9 high near $1.32.
Sterling has tended to be a mixed bag on recent BOE decision days. In 2019, GBP weakened on 5 of the 8 BOE decision days. In 2020, GBP has weakened on only 2 of the 5 BOE decision days so far.
UK equities continue to underperform within MSCI World. In 2019, MSCI UK was up 11.3% and compared to 25.8% for MSCI World. So far this year, MSCI UK is -18.8% and compares to -6.8% YTD for MSCI World. This underperformance should continue, as our DM Equity model has the UK at an UNDERWEIGHT position.
UK bonds are outperforming within DM. The yield on 10-year local currency government bonds is -63 bp YTD. This is behind only the best performers the US (-126 bp), Canada (0121 bp), Hong Kong (-120 bp), Norway (-101 bp), New Zealand (-87 bp), and Singapore (-82 bp). Continued talk of negative UK rates is likely contributing to this gild outperformance.
Our latest DM sovereign ratings model update saw the UK’s implied rating fall two notches to A-/A3/A-. This suggests even stronger downgrade risks to actual ratings of AA/Aa2/AA-. Fitch cut its rating by a notch to AA- with negative outlook back in March, citing weakness in the public finances caused by the impact of the pandemic. S&P has been more forgiving, affirming its AA rating with stable outlook back in April. Last November, Moody’s moved the outlook on its Aa2 rating to negative from stable, citing policy paralysis in the Brexit era.