What to buy and sell if the BoE introduced NGDP level targeting

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1 Investment Research General Market Conditions 12 December 212 Research UK NGDP level targeting in the UK don t ignore it On 1 July 213 the present governor of the Bank of Canada, Mark Carney, will take over as new governor of the Bank of England (BoE). Therefore, any comment from Mark Carney will be taken by the markets to be relevant for not only the Canadian markets, but also for the UK markets. From a UK perspective, Mark Carney s comments overnight seem highly relevant: If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP (NGDP) level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add history dependence to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP. Carney is referring to a situation where interest rates are at the so-called Zero Lower Bound (ZLB). With interest rates close to zero, monetary policy cannot be eased further by cutting interest rates (if technical or systemic factors in practice rule out negative rates), but that does not mean that the central bank is out of ammunition. Hence, an option for the central bank stuck at the Zero Lower Bound would be to announce, for example, a target for the level of nominal GDP (NGDP). This is what Carney theoretically is suggesting. Central Banks at Zero Lower Bound 6 5 UK USA Eurozone Source: Reuters EcoWin, Danske Bank Markets UK is below pre-crises nominal GDP path 27, 26,9 ln(ngdp) ln(ngdp) 26,8 Nominal GDP 26,7 26,6 26,5 26,4 26,3 26,2 26,1 26, Source: Reuters EcoWin and Danske Bank Markets 27, 26,9 26,8 26,7 26,6 26,5 26,4 26,3 26,2 26,1 26, Chief Lars Christensen larch@danskebank.dk Anders Vestergård Fischer afis@danskebank.dk Important certifications and disclosures are contained from page 4.

2 In the case of the UK and many other countries where the level of NGDP has dropped well below the pre-28 trend an announcement that the Bank of England is to bring NGDP back to the pre-crisis trend would therefore effectively be an announcement of significant monetary easing from the Bank of England. If an NGDP level target was combined with an announcement to undertake unlimited and open-ended quantitative easing to reach the target, the market and economic impact is likely be very strong. How the BoE would reach such a goal is uncertain. So far, the BoE has been one of the most expanding major central banks in terms of increasing its balance sheet. In the current Asset Purchase Programme, the BoE has been buying gilts of GBP375bn, now holding 34% of all outstanding gilts. Recently, we have also seen the FED signalling a more rule-based monetary policy. However, so far, we have not seen the full effect in market pricing partly due to mixed signals in communication and lacking consensus on what form the final rule will take. Obviously, Carney is not saying that the BoE will (or shall) do that under his leadership but his comments are nonetheless noteworthy. There are two reasons for this. First, contrary to the Bank of Canada, the BoE is at the ZLB so it is obvious that further monetary easing in the UK would have to involve looking at the BoE s inflation target directly or indirectly. Second, according to media reports, the UK government is open to discussing the BoE s monetary target and some cabinet members have even suggested that the BoE should introduce an NGDP level target. Carney s comments overnight therefore are likely to increase both market and media attention to this and as such it could easily become a market mover for the UK markets in coming weeks and months. Note also that the Bank of Canada under Carney s watch has been discussing implementing a price-level targeting, so Carney is very much at the centre of this debate. Expanding Central Bank balances 5 Index (1/1/28 = 1) 4 UK USA Eurozone Source: Bloomberg, Danske Bank Markets In our view, these signals from Carney could be the first baby steps in the direction of introducing an NGDP level target. The UK government has repeatedly stressed that its strategy to pull the UK economy out of the crisis is a combination of fiscal tightening/consolidation and monetary easing. The UK government is delivering on the first part through its austerity measures (though extended to 218 in last week s Autumn Statement). By introducing an NGDP level target, the BoE would commit itself to delivering on the monetary easing part. One option is of course that it could introduce NGDP level targeting as a operational tool, but another more radical option might simply be that the UK government would change the legislation to change the BoE s mandate from inflation targeting to NGDP level targeting. The second option obviously would be the most potent solution. It should be stressed that all this is speculation but given Carney s comments and the obvious interest in NGDP level targeting among certain UK government ministers and officials, it would be wrong from a market perspective to ignore the discussion about a possible change to the UK monetary policy set-up. What to buy and sell if the BoE introduced NGDP level targeting If we hypothetically assume that the UK government and BoE tomorrow announce that the BoE will start undertaking unlimited quantitative easing to bring back the level of NGDP to the pre-crisis trend level then the implications for the UK economy and markets seem pretty obvious. First of all, this would be a significant boost to domestic demand in the UK economy and therefore likely raise (real and nominal) GDP growth and reduce unemployment. BoE Asset Purchase Programme 4 GBPbn Up to 5y 5-1y 1-15y 15y+ Source: Bank of England, Danske Bank Markets Second, higher growth and inflation expectations would obviously increase long-term UK bond yields and the yield curve would be likely to steepen significantly December 212

3 An aggressive QE programme would put the BoE back as a powerful buyer of gilts, where it so far primarily has been buyers in the 5-15 year segment (68% of all purchases). Third, with the BoE announcing a stepping up of monetary easing, the British pound would be likely to take a significant beating, which on its own would help UK growth (see also our Top 1 trades for 213, from 5 December 212, where we recommend being short GBP against NOK). We think these trades are quite obvious. However, it should be stressed that neither the UK government nor Mark Carney has endorsed NGDP targeting. Therefore, it is in no way a given that the markets will start to price in NGDP targeting now. However, it is our expectation that the discussion will gain momentum, which in itself could become market moving December 212

4 Disclosure This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ( Danske Bank ). The authors of this research report are Lars Christensen, Chief,, Senior and Anders Vestergård Fischer,. Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Services Authority (UK). Details on the extent of the regulation by the Financial Services Authority are available from Danske Bank upon request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial s rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of highquality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors upon request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research has been prepared by Danske Bank Markets (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change, and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided in this research report. This research report is not intended for retail customers in the United Kingdom or the United States December 212 Chief Lars Christensen larch@danskebank.dk Anders Vestergård Fischer Anders Vestergård Fischer

5 This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank s prior written consent. Disclaimer related to distribution in the United States This research report is distributed in the United States by Danske Markets Inc., a U.S. registered broker-dealer and subsidiary of Danske Bank, pursuant to SEC Rule 15a-6 and related interpretations issued by the U.S. Securities and Exchange Commission. The research report is intended for distribution in the United States solely to U.S. institutional investors as defined in SEC Rule 15a-6. Danske Markets Inc. accepts responsibility for this research report in connection with distribution in the United States solely to U.S. institutional investors. Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the independence of research analysts. In addition, the research analysts of Danske Bank who have prepared this research report are not registered or qualified as research analysts with the NYSE or FINRA but satisfy the applicable requirements of a non-u.s. jurisdiction. Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant Financial Instrument may do so only by contacting Danske Markets Inc. directly and should be aware that investing in non- U.S. financial instruments may entail certain risks. Financial instruments of non-u.s. issuers may not be registered with the U.S. Securities and Exchange Commission and may not be subject to the reporting and auditing standards of the U.S. Securities and Exchange Commission December 212

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