Investment Research General Market Conditions 4 February 2016 BoE review BoE is not Fed light we now expect first hike in Q1 17 The Bank of England has made it clear that it is definitely not Fed light. There are many reasons for the BoE to stay on hold for a long time: subdued wage inflation, ECB on an easing bias and Brexit uncertainties to mention a few. Subdued inflation one of many reasons for BoE to stay on hold As a consequence, we have moved our call for the first BoE hike to Q1 17, probably in February (previously Q2 16, probably in May). We have lowered our UK interest rates forecasts across the curve but we still project higher UK interest rates over the medium-term horizon as the BoE is priced too dovishly. We see EUR/GBP trendless and volatile in the coming months but stress that risks are skewed to the upside around the time of the EU in/out referendum. We have for some time argued that BoE was Fed light as the economic developments in the two countries have been quite similar, especially in the labour markets. However in a recent speech, Carney gave us five reasons why BoE is indeed not Fed light. 1) Cost pressures in the UK are lower than in the US, 2) the UK is more open than the US, 3) pass-through from easing bias among other central banks, 4) large fiscal headwinds and 5) the BoE has macroprudential tools. Today s BoE meeting echoed Carney s dovish message. Ian McCafferty, the most hawkish member of BoE s Monetary Policy Committee (MPC), changed his stance and no longer votes for an immediate rate increase. Thus the vote count for unchanged monetary policy was once again 9-0. As expected, the paths for inflation, GDP growth and the unemployment rate were all lowered in the Inflation Report. There are many reasons why the BoE will stay on hold. Inflation and wage growth are both subdued, inflation expectations have fallen and Brexit uncertainties loom. Moreover, growth slowed in 2015 compared to 2014, although growth is still around (or more likely slightly above) trend levels. The only really bright spot left in the BoE s chart book is the labour market, which, however, has not normalised completely yet as the BoE still thinks there is some slack left. The BoE argues that long-term unemployment is still elevated and many part-time workers are not able to find full-time work. Also the BoE fears that wage growth will stay subdued due to second-round effects kicking in. In the current noflation environment, real wage growth equals nominal wage growth and thus the demand for further nominal wage growth is subdued. Finally and perhaps most importantly, other central banks have stepped up monetary policy easing recently, with the ECB now expected to ease in March, the Bank of Japan having introduced a negative policy rate in January, and market participants no longer expecting that the Fed will hike this year. In this respect we note that being on hold is actually quite hawkish in the current environment and consequently we see little prospects of a BoE rate hike this year. We have thus postponed our expectations of the first BoE hike to Q1 17, probably in February (previous Q2 16, probably in May). Source: ONS Unemployment one of the few bright spots left in BoE s chart book Source: ONS, Bank of England Market s pricing of BoE 1.20% 1.00% 0.80% 0.60% 0.50% -0-2 -4-7 -7-8 -6 0.40% 0.20% Source: Danske Bank Markets Senior Analyst Morten Helt + 45... mohel@danskebank.dk Analyst Mikael Olai Milhøj +45 45 12 76 07 milh@danskebank.dk GBP/OIS forward market +13 +17+20+24 +9 +5 +2-2 0.00% Feb16 Aug16 Feb17 Aug17 Feb18 Aug18 Current Live Policy Rate +28 +31+35 Important disclosures and certifications are contained from page 6 of this report. www.danskeresearch.com
We have lowered our UK interest rates forecasts Due to the postponement of the first BoE rate hike and due to the recent decline in sterling and global interest rates, we now see less potential for higher UK interest rates in the near term. We have thus lowered our 1M, 3M and 6M UK interest-rate swap forecast some 20-30bp across the curve, projecting a fairly flat development in UK interest rates in the coming 1-3 months. However, a lot of pessimism is already priced in on the UK economy, with a nearly one-third probability of a rate cut priced into the UK money market by the end of 2016. This is very much in contrast to the whole MPC s view which thinks that next rate move will be up. Further out, the first full 25bp rate hike is priced to arrive in August 2018 followed by only one rate hike per year in the following years. Once it has started, we expect the BoE to conduct a hiking pace of three rate hikes per year, taking the Bank Rate to 1.25% by the end of 2017. This should lead to higher UK interest rates over the medium-term horizon. We now forecast 5-year UK swap rate at 1.75% in 12M (revised down from 2.15%) and our 6M and 12M yield forecasts are above the forward market across the curve. EUR/GBP trendless and volatile in the coming months GBP has started the new year on a very weak note and while the postponement of a BoE rate hike in isolation implies upside risks to our EUR/GBP forecasts, we note that the BoE is already very dovishly priced for 2016. As such, we expect headwinds from relative rates to ease going forward and in a scenario with fewer global growth concerns, the relative rate channel could in fact support a lower EUR/GBP in the coming 3-6M. However, we see little prospects of a strong GBP rally in the coming months due to the looming EU referendum. Indeed, a substantial Brexit risk premium is already priced into the FX option market, but GBP might still suffer due to rising uncertainty as the referendum moves closer. In all, we look for EUR/GBP to be fairly trendless and very volatile in the coming months with the risks skewed towards further EUR/GBP upside going into a possible EU referendum in June. We are currently reviewing our EUR/GBP forecast which will be published in the next FX forecast Update due mid-february. New interest rate forecast GBP Spot +3m +6m +12m Source: Danske Bank Markets Money market Base rate 0.50 0.50 0.50 0.75 3M 0.59 0.59 0.59 0.85 Government bonds 2-year 0.39 0.50 0.70 1.10 5-year 0.91 1.00 1.20 1.55 10-year 1.59 1.65 1.80 2.05 Swap rates 2-year 0.79 0.90 1.10 1.50 5-year 1.12 1.20 1.40 1.75 10-year 1.58 1.70 1.85 2.10 Brexit risk premium priced into FX option market (1Y GBP put options have become expensive) Source: Bloomberg, Danske Bank Markets See overleaf for Carney s chart book 2 4 February 2016 www.danskeresearch.com
Carney s chart book Private consumption main growth UK grew at a slower pace in 2015 compared to 2014 Private consumption grows at solid pace Source: ONS, Danske Bank calculations Source: ONS, Danske Bank calculations GDP growth vs. growth in US and euro area BoE has lowered growth outlook and sees downside risks Source: ONS, Eurostat, BEA, Danske Bank calculations Source : ONS, Bank of England Cost pressures lower in the UK than in the US UK unit labour costs still subdued lower than in the US However, total ULC hides that unit wage costs are growing the fastest since the crisis Source: ONS, BEA Source: ONS, Danske Bank 3 4 February 2016 www.danskeresearch.com
4-quarter change in unemployment (pp) BoE review UK an open economy exposed to ECB s easing bias UK twice as open as the US UK is exposed to developments in the rest of Europe takes ECB s easing bias into account Source: ONS, BEA Note: Only goods exports. December value set equal to November. *EU including Norway and Switzerland. China** including Hong Kong Source: ONS Labour market one of the few bright spots left in the chart book Unemployment rate has declined sharply in 2015 Unemployment rate has fallen more than expected from GDP growth Source: ONS Q Source : ONS, Danske Bank calculations, sample is 1972 Q1 to 2015 Q3 4 3 2 1 0-1 -2 Whole sample 2014-15 Linear -3-6 -4-2 0 2 4 6 8 10 GDP growth % y/y Still slack left. Many workers are unable to find full-time jobs Long-term unemployment still elevated Source: ONS, Danske Bank calculations Source: ONS 4 4 February 2016 www.danskeresearch.com
BoE is afraid of 2nd round effects on wage growth Inflation expected to stay low in 2016 Solid real wage growth despite subdued wage growth as inflation is around 0% Source : ONS Source : ONS, Danske Bank 5 4 February 2016 www.danskeresearch.com
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