No UK rate hikes this year and room for further Euro upside
The odds of a 25bp Bank of England rate hike at next week’s policy meeting are all but dead in my view following tepid GDP growth of 0.3% qoq in Q2 2017.
Moreover, UK GDP growth and inflation dynamics, allied to forthcoming changes in the composition of the Monetary Policy Council, point to the record-low policy rate of 0.25% remaining on hold for the remainder of the year.
Forecasting European Central Bank (ECB) monetary policy, including the timing and modalities of changes to its Quantitative Easing program, is arguably a far trickier proposition.
While the ECB may be incentivised to slow the current rapid pace of Euro appreciation, at this stage I do not expect the ECB to try and to stop, let alone reverse, the Euro’s upward path.
Sterling making small inroads but not against a surging Euro
While Sterling has recovered slightly against the currencies of its key trading partners, in particular the US Dollar, it has continued to lose ground versus the Euro (see Figure 1). The GBP/EUR cross has now weakened 6.4% since 21 April 2017 when I reaffirmed my constructive outlook for the Euro (see French politics, UK macro data and possible GBP/EUR downside). I expect weak UK GDP growth and weak underlying inflationary pressures to kick any Bank of England (BoE) rate hikes into 2018. If correct, this would likely see market pricing for an end-of-year hike fade further from 11bp currently and remove further for support for Sterling even if the unpredictable Brexit narrative remains an important currency driver.
The Euro side of the equation is arguably as, if not more tricky to predict. Peripheral Eurozone yields have been falling in tandem with Euro appreciation with the net effect being that monetary conditions have not tightened much. My take is that markets believe that the ECB is in no rush to announce let alone initiate a tapering of its QE program, which in turn means loose monetary policy for longer (even if Euro appreciation equates to some tightening). This should help extend the eurozone’s economic recovery, which in turn is positive for (peripheral) countries’ fiscal balances, sovereigns bonds and finally the Euro. Put differently, the ECB is allowing a change in the mix of monetary policy which is good for both bonds and the Euro.
Risk of ECB stopping Euro appreciation muted at this stage
There is still admittedly still much uncertainty as to when and to what extent the European Central Bank (ECB) will tweak its forward guidance, let alone when and how it will announce changes to the modalities of its QE program and numerous policy instruments. Moreover, there is a risk that the ECB, spurred by the eurozone’s two largest exporters – Germany and France – tries to at least slow the current pace of Euro appreciation, with in a first instance verbal intervention, in a bid to preserve export competitiveness. As Figure 2 shows, the monthly pace of appreciation in the Euro Nominal Effective Exchange Rate (NEER) picked up further in July, to around 1.9% according to my estimates.
However, should the Euro continue to appreciate at an orderly pace, I see limited risks of the ECB or major eurozone countries trying to stop, let alone reverse the Euro’s current trend. For starters, while the Euro’s ascent has been rapid (and arguably unexpected) in recent months, in level terms the Euro NEER is still within, albeit at the high end, of the narrow 15% range in place since early 2010 according to my estimates (see Figure 3). The Euro NEER was about 0.6% stronger at its peak in mid-March 2014.
This may come as a surprise as markets understandably focus on the EUR/USD cross and EUR/GBP crosses, which are up about 13% and 6.7%, respectively since end-December. But the Dollar and Sterling account for “only” 12.7% and 10.3% of the Euro NEER according to the ECB – this incidentally broadly tallies with the share of German exports destined for the United States (9%) and UK (7%). The Euro’s appreciation against other major trading partners’ currencies has been far more modest (see Figure 4).
Moreover, a significant share of eurozone member states’ merchandise exports goes to other member states. For example, about 37% of German exports went to other eurozone countries in 2016. So in theory over a third of Germany’s exports are not directly currency sensitive even if in practice if a strong Euro is depressing other eurozone countries’ exports, this may in turn depress their imports and demand for German goods. There are certainly few signs so far that the stronger Euro is curbing German exports or confidence, with the German IFO Business Climate Index reaching a third consecutive record high of 116 in July 2017 (see Figure 5).
Bank of England – Odds of August rate hike virtually nil, odds of end-year hike very low
Weak (preliminary) GDP growth in the UK of 0.3% qoq in Q2 has reinforced my view, first expressed in June, that the probability of the BoE Monetary Policy Council (MPC) hiking its policy rate from a record-low 0.25% at its 3rd August meeting is very low (see H2 2017: Something old, something new, something revisited, 23 June 2017). Financial markets, which had priced in a modest chance of a summer hike following the June MPC meeting, have now rightly in my view all but discounted the odds of the MPC hiking rates next week.
This first estimate of Q2 GDP is based solely on output-data and precedent points to possible revisions when the second and final estimates are published on 24th August and 29th September, respectively (see ONS). However, I am sticking to my view that the UK economy’s weakness and uncertainty associated with the Brexit process are sufficient hurdles for the MPC to look through a temporary rise in inflation and refrain from hiking policy rates any time.
GDP growth failed to materially recover in Q2 2017 from 0.2% qoq in Q1, in line with my forecast (see UK: Land of Hope & Glory…but mostly Confusion, 7 July 2017). This resulted in GDP growth of only 0.5% in H1 2017 – the second lowest first-half print since end-2012 (see Figure 6).
Moreover, growth was very unbalanced with the UK economy effectively running on only one engine – services. Production and construction subtracted from headline growth while agriculture is too small too matter. The services sector, which accounts for about 80% of the UK economy, recorded growth of 1.5% qoq in Q2 thanks in part to a sharp rebound in retail sales in June and strong performance by the motion picture industry. This countered a 1.5% contraction in Q1, resulting in the services sector added nothing to GDP growth in H1 2017.
Production, of which manufacturing accounts for 60%, and construction output weakened 0.4% and 0.9% respectively in Q2, and as a result both shaved off 0.06 percentage points (pp) from headline growth (see Figure 7). Agriculture accounts for only 0.7% of the UK economy so 0.6% qoq growth in Q2 was largely immaterial (it added 0.0042pp to GDP growth).
The odds of the eight-member MPC hiking its policy rate of 0.25% on 3rd August are now virtually nil. While MPC member Andrew Haldane may join Michael Saunders and Ian McCafferty in voting in favour of a 25bp hike, new member Silvana Tenreyro is likely to vote in favour of no change which would result in a 3 versus 5 vote in favour of rates remaining on hold. Importantly, I believe that Governor Carney – who has the casting vote in the event of a 4 versus 4 tie – will again vote for no change, even if he has had a tendency to blow hot and cold.
The BoE will have a further three policy meetings this year – on 14th September, 2nd November (when it will also publish its quarterly inflation report) and 14th December – but I see no material reason at this stage to change my view that a rate hike before end-year is unlikely.
Not clear where significantly faster GDP growth will come from
The risk is now that the BoE’s full-year GDP growth forecast of 1.9% will be missed by a potentially significant margin and I would expect the BoE to revise down its forecasts when it publishes its quarterly inflation report on 3rd August. In order for the UK economy to grow 1.9% this year, GDP growth in H2 2017 would have to hit 1.4% – almost three times as fast as in H1 and the second fastest rate in the second half of the year since 2007 (growth hit 1.6% in H2 2014 – see Figure 6). The IMF, in its 24th July 2017 World Economic Outlook, revised down its forecast for 2017 GDP growth in the UK to 1.7% (from 2.0%) but that still looks optimistic in my view.
It is simply unclear what will drive significantly faster domestic growth in H2 2017.
- Falling real wages, pressure for banks to curb lending, stagnant property prices, a record-low household savings rate, high levels of household indebtedness and political uncertainty continue to hold back underlying retail sale volumes and in turn household consumption and GDP growth.
- Investment has slowed in a number of sectors and will likely be curtailed as a result of Brexit-related uncertainties. Investment in the auto sector in H1 2017 was running at about a quarter of where it was only two years ago, as companies delay or shelve investment plans. Negotiations between the UK and the EU continue to progress at a glacial pace although more positively British cabinet members have moved closer to agreeing to a still-to-be-defined transitional arrangement (following the UK’s exit from the EU in March 2019).
- Export growth has picked-up but so has import growth, resulting in a still large trade deficit (despite the 18% gain in Sterling competitiveness in the past 18 months) and little support for overall GDP growth.
On the supply side, industrial output continued to flat-line in April-May 2017 and June manufacturing PMI data are not particularly encouraging (see Figure 8). The latest Confederation of British Business (CBI) survey for July points to a strong ongoing recovery in manufacturing output, exports and orders but the breakdown in the correlation between CBI manufacturing orders and actual output suggests that it needs to be treated with a pinch of salt (see Figure 9).
In any case the manufacturing sector accounts for only 10% of UK economy (versus 80% for services) so it has to growth very quickly to have an even marginally positive impact on overall GDP growth – for example it would have to grow at 1% qoq to add just 0.1pp to overall GDP growth
UK CPI-inflation may be near its peak if another major Sterling downturn is avoided
The combination of weak economic growth, falling real wages and downturn in imported inflation suggest that headline and in particular core CPI-inflation, which fell in June, are unlikely to rise sufficiently to warrant a rate hike. Inflation may even fall more forcefully in coming months unless Sterling weakens materially, as I argued four months ago in Bank of England and inflation – Sense of Déjà-vu, 24 March 2017.
Figure 10 shows that the pace of year-on-year depreciation in the Sterling NEER fell sharply to about 3.5% in July 2017 from 20% in October 2016, as a result of base effects (namely the older and stronger NEER levels falling out from the calculations). Unsurprisingly, this in turn contributed to a fall in the year-on-year rate of imported inflation in April-May. Should Sterling remain broadly unchanged going forward, its year-on-year pace of depreciation would slow further towards zero in coming months and even briefly turn to appreciation in October, according to my estimates.
This would further dampen imported inflation and, albeit with a likely lag, headline CPI-inflation in my view. This phenomenon is arguably already in play. Figure 10 shows a decent correlation between imported and headline CPI-inflation, with a lag of a few months as retailers are not always able and/or willing to immediately pass on higher imported prices to consumers. While imported inflation fell in April and May, headline and core CPI-inflation only fell in June, to respectively 2.6% yoy and 2.4% yoy from 2.9% and 2.6% respectively in May.
Moreover, I continue to expect tepid nominal wage growth to act as a headwind to CPI-inflation, which could conceivably fall towards the BoE’s 2% target at the turn of the year (see Figure 11). Slow economic growth, labour productivity now below end-2007 levels and a still reasonably large pool of available – see Figure 12) are likely to continue weighing on workers’ ability to negotiate higher earnings and in turn nominal wage growth.
With this in mind, I am sticking to my base-line scenario that the BoE will look beyond any blip higher in UK inflation, unless at least one of three conditions materialise: (1) Nominal wage growth accelerates, comfortably outstripping headline inflation and driving consumption growth; (2) Commercial bank lending picks up significantly; and (3) Sterling depreciates materially from current levels, exacerbating imported and in turn headline inflation. Even a sharp downturn in Sterling may be insufficient to prompt a policy rate hike if the underlying cause is weak economic growth and/or set-backs relating to Brexit negotiations.
Scheduled changes in the composition of the MPC will also reduce the probability of a rate hike this year, in my view. Dave Ramsden, who was Chief Economic Advisor to the Treasury, is due to join the MPC in early September as Deputy Governor so that nine (rather than the current eight) members will vote at the 14th September and subsequent policy meetings (see Figure 14).
Assuming that McCafferty, Saunders and Haldane vote for a 25bp hike next week, they would have to be joined by not one but two members in September for a hike to take effect. None of the other members have signalled their willingness to vote for a hike and precedent suggests that Ramsden will vote along with the majority at least in his first few policy meetings. Even if Carney, who has the casting vote, voted for a hike this would still result in a five versus four vote in favour of no change. Put differently, with an eight-member MPC Carney’s vote effectively counts as two but this will no longer the case in a nine-member MPC. So purely from a numerical perspective, the bar for a hike will go a little higher from September onwards.