At the beginning of January, the market was expecting very little from the Bank of England in 2020. There was a widespread view from outside the MPC that the committee was opposed to the negative interest rate policy adopted by the ECB but at the same time, despite the optimism of a post-election boost for the economy, expectations of tighter policy were still very remote.
However, sentiment shifted dramatically after MPC member, Gertijan Vlieghe, followed some dovish comments from Mark Carney and told the FT that he would vote for a rate cut if key data did not show signs of an economic recovery. After disappointing manufacturing and industrial production figures were published a day later, the market concluded that the MPC would cut rates at their meeting on 30th January. The implied probability of a cut (calculated using the OIS curve) rose from 7.5% at the beginning of the month to 67% on 15th January.
This proved to be a case of the market getting ahead of itself and in the end, the MPC voted 7-2 in favour of keeping rates unchanged at 0.75% with Carney stating, “the most recent signs are that global growth has stabilised.”
Is a cut still warranted?
Recent data has certainly taken the pressure off the MPC to cut rates in the near term. The Citi surprise index shows a notable uptick in recent weeks where numerous UK data points have exceeded expectations (the index uses a simple methodology where each data point scores +1 if the release exceeds the consensus forecasts or -1 if it is below expectations).
Most notably, the forward-looking PMI surveys for January showed a marked uplift in both the manufacturing and service sectors. Whether the recent trend of improving sentiment can continue remains to be seen, but for now, the market seems content that rates are likely to remain on hold for the time being (a cut isn’t priced in until August).
What are the risks?
- Global economic outlook – in the near term, the biggest threat is Coronavirus. At this stage, the knock-on impact on the global economy is still uncertain. This morning, the market took some comfort from additional Chinese stimulus coupled with the news that a number of major manufacturers, including Sony and Apple, have been given the green light by Chinese authorities to resume production. However, there are many more firms that continue to remain on lock-down.
- Brexit uncertainty – Boris Johnson remains adamant that he won’t ask the EU for an extension to the transition period beyond the end of 2020. This leaves a relatively small window to negotiate the terms under which Britain and the EU will trade in the future. If it becomes apparent that a deal may not be forthcoming, UK economic activity may start to slow again as investors return to wait-and-see mode.
- Sterling – while the Bank of England doesn’t target a specific level for sterling, the MPC appears comfortable with the notion that a weaker pound helps UK growth. From an inflationary standpoint, consumer prices have been relatively steady, just below target in recent years so the last thing the bank wants/needs is a strong pound dampening import prices.
With the market not forecasting any change in interest rates until August, the risk in the near term is that an unexpected downturn prompts a change in thinking from the MPC. Given a perceived willingness to cut rates in January, it probably won’t take much to fuel expectations of a cut once again. Such expectations would almost certainly have a negative impact on sterling, at least in the short term.
Longer-term, the outlook is still relatively dull. We continue to believe that the committee are not in favour of negative rates so see little scope for deeper cuts. Additional QE remains a possibility if economic conditions deteriorate markedly, but given all the uncertainty over the benefits, we only expect the committee to deploy such measures in extreme circumstances.
From an FX perspective, this supports our mildly bullish outlook for the pound, although with little prospect of a rate hike anytime soon, the outlook for monetary policy is unlikely to be the main driver for a move higher in the pound.
Author: Marc Cogliatti