Investment Research General Market Conditions 1 August 2016 Bank of England Preview Substantial package of easing measures We expect the Bank of England BoE to announce a substantial package of easing measures on Thursday. We expect the BoE to cut the Bank Rate by 25bp, down to 0.25%, and look for an expansion in its stock of purchased assets of GBP75bn. Moreover, we also think it is likely the BoE will ease through its Funding for Lending Scheme. We expect the BoE to maintain a very dovish stance signalling readiness to ease further if necessary. In our view, this should help underpin the market s expectation of additional easing further down the road. We estimate that just over 25bp worth of rate cuts and some additional QE has already been priced in but we still think risks for interest rates and GBP are skewed on the downside despite relatively high market expectations. We expect the GBP to weaken versus the EUR and the USD on the announcement, forecasting EUR/GBP will rise to 0.86 in 1M. Over the medium term, we expect further GBP weakness, forecasting EUR/GBP at 0.88 in 3M and 0.90 in 6M. We expect BoE to deliver a substantial easing package Post-Brexit data have been very weak After the BoE disappointed slightly at July s meeting by keeping monetary policy unchanged, we expect it to announce a package of easing measures this week. In our view, the BoE preannounced easing at the July meeting, as most members of the Committee expected monetary policy to be loosened in August, according to the minutes released from the meeting. The BoE is also under political pressure as the new Chancellor of the Exchequer Phillip Hammond has said that the initial response to this kind of a shock must be a monetary response delivered by the Bank of England (see Bloomberg). Since the July MPC meeting, most post-brexit surveys (no hard data have been released yet) have been very weak, as consumer confidence, business confidence and housing market expectations have declined. Most noticeably, the PMIs have fallen below 50 supporting our view that the UK is heading into a recession in H2 16. BoE member Martin Weale (hawk, his last meeting) has shifted his view and now supports easing, as he has said that the weak PMIs will weigh significantly on the BoE s decision. In May, BoE Governor Mark Carney said the BoE is still in the conventional monetary policy space, meaning the Bank Rate is the first line of defence, and we expect the BoE to cut the Bank Rate by 25bp from 0.50% to 0.25%. This is more or less in line with consensus (0.25%) and market pricing (a little more than a full cut is priced). Moreover, we expect the BoE to restart its Asset Purchase Facility (APF) programme (QE) by buying sovereign bonds worth an additional GBP75bn. Since January 2009, the BoE has bought GBP375bn of gilts under the APF programme, which corresponds to 22% of the current outstanding amount of gilts. As the amount of outstanding gilts has increased in recent years, the ownership share has declined from 27% to 22%. By expanding the stock of purchased assets by GBP75bn to GBP450bn, the ownership share would get back to around 27%. Source: Macrobond Financial, Danske Bank Markets BoE s holding of gilts set to increase to previous high Source: Macrobond Financial, Danske Bank Markets Senior Analyst Mikael Olai Milhøj +45 45 12 76 07 milh@danskebank.dk Senior Analyst Morten Helt +45 45 12 85 18 mohel@danskebank.dk Important disclosures and certifications are contained from page 4 of this report. www.danskeresearch.com
At the same time, we also think it is also possible the BoE will ease monetary policy through its Funding for Lending Scheme (FLS) in order to avoid any supply-driven credit tightening and ensure a proper transmission of monetary policy. Given that the BoE s primary concern appears to be centred on investments and the housing market, is it likely it BoE might choose to focus on incentives for SMEs and/or households. Finally, we expect the BoE to announce that it is on an easing bias, as it stands ready to do more if the economic data continue to be weak. BoE has ruled out negative rates The BoE has very clearly communicated that it will not cut rates into negative territory. While this is no guarantee that rates will never be lowered to negative, it seems that other central banks who already have introduced negative rates, such as the ECB and Bank of Japan (BoJ), have moved away from this path (we do not expect the ECB or BoJ to cut rates further). Risks skewed towards downside for GBP and UK yields on BoE easing We estimate that just over 25bp worth of rate cuts at this week s Monetary Policy Committee meeting has already been priced in by the UK money market, while the overnight interest rate is priced to fall to 0.15% by the end of 2016. In the fixed income space, both 2Y10Y and 5Y10Y gilt yields curves have flattened substantially since the UK s EU referendum, which implies that some expectations of renewed asset purchases have also been priced in. If we are correct that the BoE will cut by 25bp and do more QE on Thursday, we think risks for interest rates and GBP are skewed on the downside despite relatively high market expectations, as we expect the BoE to maintain a very dovish stance signalling readiness to ease further if it finds it necessary. This should help underpin the market s expectations for additional easing further down the road. Thus, we expect yields to fall a bit across the gilt curve in the UK, while the 2Y10Y and 5Y10Y curves could see further flattening pressure. In the FX market, we see risks skewed towards a weaker GBP versus the EUR and USD on the announcement and we forecast EUR/GBP will rise to 0.86 in 1M. GBP outlook: more weakness in store On a three- to six-month horizon, we think the substantial current account (CA) deficit of around 5% of GDP in the UK combined with high uncertainty about near-term FDI and portfolio flows into the UK, implies a sharp fall in domestic demand and a weaker GBP to support exports. We forecast EUR/GBP at 0.88 in 3M, 0.90 in 6M. Longer term, we expect the GBP will stabilise to some extent given attractive valuations. With EUR/GBP at 0.90, both our Medium-Term Valuation Model (MEVA) and PPP models suggest the GBP would be significantly undervalued with a close to 2 sigma deviation from fair value estimates of 0.769 and 0.780 (MEVA and PPP, respectively). We target EUR/GBP at 0.88 in 12M. BoE pricing: a full 25bp cut is already priced for this week s meeting 0.60% 0.50% 0.50% 0.40% 0.30% 0.20% 0.10% -6-13 -15-15 -15-16 -15-15 -14-14 -13-13 -12 0.00% Jul16 Jan17 Jul17 Jan18 Jul18 Source: Danske Bank Markets EUR/GBP forecast 0.95 0.90 0.85 0.80 0.75 0.70 GBP/OIS forward market Current Live EUR/GBP Source: Danske Bank Markets Policy Rate 0.65 Aug-15 Nov-15 Feb-16 May-16 Sep-16 Dec-16 Mar-17 Jul-17 75% conf. int. 50% conf.int. Forward Danske fcst Consensus fcst k EUR/GBP 1M 3M 6M 12M Forecast (pct'ile) 0.86 (72%) 0.88 (81%) 0.90 (83%) 0.88 (69%) Fwd. / Consensus 0.85 / 0.85 0.85 / 0.85 0.85 / 0.85 0.85 / 0.84 50% confidence int. 0.83 / 0.86 0.82 / 0.87 0.81 / 0.88 0.80 / 0.89 75% confidence int. 0.82 / 0.88 0.80 / 0.89 0.79 / 0.91 0.77 / 0.94 2 1 August 2016 www.danskeresearch.com
Danske Bank s PPP estimate Danske Bank s Medium-Term Valuation Model (MEVA) Source: Bloomberg, Danske Bank Markets Source: Bloomberg, Macrobond Financial, E-views, Danske Bank Markets 3 1 August 2016 www.danskeresearch.com
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