Has the BoE Positioned Cable to Make Further Gains with a Steeper Policy Outlook?

Looking ahead, cable looks on course to make further gains

Readers will recall that in early May the question was raised here of the UK’s path back to monetary policy normalisation being too slow and too shallow. In the space of under one week the Monetary Policy Committee (MPC) appears to have addressed that question, external member Gertjan Vlieghe suggesting the Committee is moving away from its ultra-dovish position towards a more neutral stance, and Deputy Governor Ramsden saying it will be vigilant in responding to inflationary threats.

Both messages have suggested a UK recovery proving stronger than anticipated, potentially necessitating a more robust monetary response. So what has changed since the May MPC meeting, when the dovish stance was repeated, to make it change tack now?

What is driving this shift in policy stance?

The shift in stance is almost certainly predicated on the strong rebound in UK activity ensuing this year – the BoE itself upgraded its 2021 growth forecast from 5% to 7.5% – and being reflected not only in stronger GDP but also in higher CPI and lower unemployment numbers.  Until now the MPC has largely focused on the latter as the key factor in determining how quickly monetary policy might return to a neutral stance, labour market slack seen as sufficient to ensure emerging inflationary pressures remain ‘transitory’.

But this ‘slack’ has so far been smaller than anticipated, the Government’s furlough scheme credited with saving jobs, and even though the BoE’s most recent forecast shows unemployment rising from 4.8% to 5.4% once the scheme finishes end-September, the labour market recovery to date suggests unemployment could instead continue falling. This will provide an unexpected extra boost to demand with the potential to pull inflation higher. This is the concern of Vlieghe.

Ramsden’s comments suggest nervousness over inflation. If households spend more of their excess savings than anticipated (the BoE forecasts 10% spent over the next three years; it is not unrealistic to think it will be higher) demand will be boosted further, and data so far suggests the UK propensity to spend is high. The savings stock was estimated at £163bn, or 7.7% GDP, at end-March. BoE/NMG data suggests the proportion of savers planning to spend some of this excess has risen from 10% in Q3 2020 to 28% in Q1 2021.

Factoring in that the services sector remains yet to fully re-open, then the potential for aggregate consumption to increase further appears significant. Ramsden may be flagging the MPC is starting to worry about this, beginning to see what they labelled as ‘transitory’ inflation becoming more ‘sustained’.

Finally, it is not inconceivable that the BoE has underestimated the damage done by the pandemic to potential supply. In May it forecast output would recover to within about 1.25% of its pre-pandemic level, an improvement on February’s forecast of 1.75%. But if this proves to be too optimistic then further fuel will be added to the inflation fire.

The message from the MPC remains that policy will not be tightened until clear evidence is seen of the output gap being eliminated and the 2% inflation target placed on a sustainable footing. There is no suggestion it is moving to abandon these yardsticks. But with Vlieghe warning a stronger labour market could deliver a faster monetary response, and Ramsden suggesting growing apprehension over rising CPI, possibly there are concerns that the “clear evidence” needed could be seen in Q1, with the potential to see a first interest rate rise delivered soon afterwards.

Is the MPC trying to position itself more closely with market thinking?

The MPC is in good company in acknowledging a stronger UK recovery. The FTSE 100-share index has gained some 7.3% over the past three months, while the steady re-opening of the UK from lockdown restrictions has seen the anticipated consumer-led recovery begin to materialise. April’s retail sales figures showed monthly volumes already exceeding their 2019 average while high-frequency data is showing consumers both spending and eating into their excess savings.

But consensus with the markets has not be as strong when recognising the potential inflationary consequences of this strong recovery. The MPC has been seen as behind the ‘policy curve’ with its fixation on ‘transitory’ inflation, seeing yields rise this year as the market has imposed its own financial tightening. Perhaps the MPC is now trying to reposition itself more closely with the market, especially given the departure of the BoE’s Chief Economist, Andy Haldane, the arch-hawk who was seen as most closely in tune with market thinking.

What are the implications for cable?

It is not a great leap of faith to conclude that the next move in interest rates will be upwards, the prospect of negative rates now fully removed. This should be cable supportive. But beyond this, and possibly of even more importance to cable going forward, is that the policy paths of the BoE and the Fed now appear to be diverging.

In less than one week the MPC has acknowledged the possibility of a stronger labour market recovery, sustainable inflationary pressures, and the potential for interest rates to be raised sooner. In contrast, the FOMC continues to emphasise an ultra-loose stance that will remain in place for the foreseeable future, despite the positive data emerging. Going forward, cable looks on course to make further gains.

Opinion editorial by Stuart Cole, Head Macro Economist at Equiti Capital

‘’This material is provided for informational purposes only and does not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by Equiti Capital. This material is not, and is not intended to be, a “research report”, “investment research” or “independent research” as may be defined in applicable laws and regulations worldwide. Please see the full disclaimer here: https://www.equiticapital.co.uk/media/11057/disclaimer.pdf ’’

Is the UK’s Forecast Path to Monetary Normalisation Too Slow and Shallow?

Viewed against February’s +2.2% reading and January’s -8.1%, an argument can be made that consumer confidence is rapidly returning, auguring well for a strong post-pandemic recovery. However, could this returning confidence be too strong? Specifically, could it see the large savings stock accumulated over the pandemic finance a spending surge capable of steepening the trajectory to monetary normalisation?

Will the UK savings rate return to its long run average?

The unknown variable when discussing the strength of consumption recovery is the degree to which households will draw upon savings to finance excess spending. Averaging around 8.5% since the 1960s, ONS figures show the savings ratio rose to 25.9% in Q2 2020 before dropping to a still high 16.1% in Q4. Not only can these savings be viewed as an intertemporal substitution of consumption, but also an increase in wealth.

Historically, around 5% of excess wealth is spent each year, a figure being used by the BoE in its policy forecasts. However, given how these savings have been accumulated – forced consumption compression rather than an aspiration to save – it is reasonable to think that once lockdown restrictions are removed more than 5% will be spent, with the savings ratio also falling back to its long run average. Further, BoE figures show these savings have largely accumulated in deposit accounts rather than repositories such as pension funds and equities, increasing the temptation to draw on them given their easy access.

How much recourse to savings will be made?

The strength of any savings-fuelled spending spree is unknown at this stage. With the bulk of these savings accumulated by higher income households and pensioners, with typically a lower propensity to consume, it may be only modest. Much may therefore depend on the behaviour of lower income households. But in the opposite direction, the boom in ‘staycations’ expected this summer will provide an atypical boost to domestic expenditure. Overall, it remains unclear exactly how things will pan out. But the evidence so far suggests it is an issue that should be sounding warnings for the BoE, with at least the acknowledgment of a potential policy response.

Will pent-up demand see the BoE falling behind the policy curve?

The lack of spending opportunities has almost certainly left pent-up demand that consumers will look to satiate going forward. High frequency data from the BoE shows card spending already rising to 89% of pre-pandemic levels from 12th April when lockdown restrictions started to be lifted; in the same vein, footfall data shows consumers returning in large numbers to shopping malls and retail outlets.

This demand will help offset the closing of the furlough scheme end-Q3, with potentially fewer jobs lost and new positions created, allowing unemployment to peak at a lower rate than the BoE is forecasting. But crucially, this removes some of the pressure expected to bear down on potential inflation. The result could be higher CPI that remains above the BoE’s 2% target next year rather than dropping back below it as currently forecast.

Normally such an increase in demand would see interest rates raised. But the BoE’s standpoint is to refrain from tightening until the economic recovery is entrenched, i.e., until spare capacity is eliminated and the 2% inflation target on a sustainable footing. Unless this message changes – and at this stage that appears unlikely – any financial tightening necessitated by this pent-up demand will be provided by the financial markets only. Official policy looks likely to remain too loose.

Do current policy assumptions need revising?

Early data suggests the BoE’s policy assumptions may be too soft, that the anticipated 5% savings-fuelled boost to consumption too conservative and that inflationary pressures might require a monetary policy response more aggressive than currently forecast. Market pricing sees a first 15bps hike delivered in Q1 2023; the proposition is that this may be too little, too late, and that a full 25bps rise may be required in 2022. And this matters more than just to the markets. Government borrowing built up over the pandemic – £303bn over the last financial year – requires financing.

While current low interest rates make this affordable, a faster and steeper rise in borrowing costs could put a hole in the Government’s fiscal plans, potentially requiring further spending cuts and/or tax rises to be made. Accordingly, both the BoE and the Government will be hoping consumers keep their excess savings in the bank.

Opinion editorial by Stuart Cole, Head Macro Economist at Equiti Capital

‘’This material is provided for informational purposes only and does not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by Equiti Capital. This material is not, and is not intended to be, a “research report”, “investment research” or “independent research” as may be defined in applicable laws and regulations worldwide. Please see the full disclaimer here: https://www.equiticapital.co.uk/media/11057/disclaimer.pdf ’’

Will The UK’s Post-Pandemic Recovery Provide Further Support For The Pound?

With the most recent GDP figures suggesting a strong post-pandemic recovery remains possible, it is not unreasonable to ask whether sterling does indeed retain the potential to trade higher.

Continued progress with Covid19 vaccinations

A key factor undermining sterling recently has been the concerns expressed over the AstraZeneca Covid19 vaccine, specifically whether restrictions on its use could cause the UK’s vaccination programme to slow, delaying the economic recovery. Recent losses do indeed look largely attributable to this story. But provided the UK public maintains confidence in the vaccine, no material impact on the pace of vaccinations should be felt; and with the Moderna vaccine now also in the UK’s arsenal, there appears no cause for anxiety that the timetable for ending lockdown restrictions will not be adhered to.

Strong recovery on-track, supported by savings-funded consumption

The UK economy is expected to bounce back rapidly once lockdown measures are finally removed, the IMF forecasting 2021/2022 growth of 5.3%/5.1%, compared to 4.4%/3.8% for the euro-zone and 6.4%/3.5% for the US. Better than expected data emerging so far this year suggests growth may be even stronger than this.  Two variables will be key signals of the possible potency of this recovery: the strength of the propensity to consume, potentially evidenced by the 12thApril reopening of non-essential retail premises; and the willingness to run down the excess savings stock built up during the pandemic to fund an excess level of consumption.

Estimated to be worth around £150bn, a run-down in savings towards pre-pandemic levels would certainly turbo-charge any economic recovery. The BoE expects only around 5% of this savings stock to be spent, a forecast predicated on rising unemployment necessitating higher precautionary savings to be maintained and on most of these savings having been accrued by retired and higher income households, with traditionally a lower marginal propensity to consume.  However, given that there will almost certainly be some element of a spending catch-up, on both goods and social activities, the suggestion is that a larger proportion of this savings stock will be spent, boosting economic activity, and potentially bringing forward a normalisation of fiscal and monetary policy.

A more supportive monetary policy

The direction of UK monetary policy has flipped this year. Negative interest rates are no longer seen and the next move in policy settings is now forecast to be a tightening.  Although current metrics are expected to remain on hold until at least Q4 2022, a stronger recovery could potentially see the need for monetary tightening to begin sooner as rising inflationary pressures demand a policy response.

Downside risks overplayed

Of course, negative factors remain. Other countries will eventually catch-up with the UK with Covid19 vaccinations, while UK lockdown measures are more restrictive than some other countries (for example, the US). The public finances remain weak, and concerns endure over the NI protocol and Scottish/Welsh independence movements. And longer term, the extent to which UK/EU trade is hindered by Brexit could also pull sterling lower.  However, a strong post-pandemic rebound should provide some offset to these negatives, while as the UK continues to sign trade deals with faster growing economies than the EU around the world, pivoting business towards these new partners could see trading volumes potentially rising higher than had Brexit not occurred.

Potential for upside gains remains

The assertion is that strong reasons for remaining positive on sterling continue, the current bout of weakness being seen as caused by short term uncertainties rather than anything more structural. The economic recovery remains on track and as this materialises so the pound will find further support. Add to this the fact sterling remains weak on an historical basis, then the potential for further upside gains appears to still be strong.

‘’This material is provided for informational purposes only and does not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by Equiti Capital. This material is not, and is not intended to be, a “research report”, “investment research” or “independent research” as may be defined in applicable laws and regulations worldwide. Please see the full disclaimer here: https://www.equiticapital.co.uk/media/11057/disclaimer.pdf ’’


Could EUR/GBP Replace Cable as The Main Outlet for a Further Rally in The Pound?

At a minimum it is hard to argue against the claim that possibly sterling has entered a consolidation phase, cable seemingly caught within a broad 1.37-1.40 channel and Eur/Gbp within a narrower 0.8550/0.8700 band. However, by the same measure, sterling continues to retain most of the gains made since September, approximately 11%/9% against the dollar/euro respectively. It is this fact that suggests underlying support for the pound remains in place.

But if this is the case, and if we are in a consolidation phase, will the same dynamics be in play once this phase has passed? Specifically, with the outlook for the US economy now looking brighter, will the main outlet for renewed sterling strength be expressed against the euro, rather than the dollar? The suggestion is that this may be the case.

Progress with vaccinations

One of the key drivers behind sterling’s ascent has been the success of the UK’s vaccination programme. Significantly ahead of the EU and to a lesser degree the US, this success has provided the prospect of the UK emerging first from the burden of lockdown restrictions and presented the opportunity for a head start in its economic recovery. While the argument with the EU over the supply of AstraZeneca vaccines could cause a slight slowing in the pace of UK inoculations, the significant advantage it will still hold over the EU cannot be ignored. While this gap exists, UK prospects will remain brighter than the EU’s, providing support for the pound vis-à-vis the euro.

Early end to lockdown restrictions and better growth prospects

Lockdown restrictions are already being eased in the UK, to be completely removed by 21st June. In contrast, further restrictions are being imposed in parts of the EU, notably Germany, Italy and France, where progress with restoring economic activity appears to be going backwards rather than forwards. Unsurprisingly, the UK is expected to outperform the EU this year: the OECD forecasts 2021 UK GDP growth of 5.1% compared to 3.9% for the euro-zone. Furthermore, the balance of risk appears tilted to the topside for the UK as opposed to the downside for the EU.

This has implications for monetary policy, the BoE expected to begin tightening ahead of the ECB. Indeed, this is already anticipated in the markets, where 10-yr Gilt yields are up some 58bps since January compared to just 26bps for their German equivalent and providing an absolute return advantage of over 1%. This interest rate differential looks set to get wider, seeing the pound become increasingly attractive to international investors versus the euro.

Confidence in the UK economic recovery

The UK Government in March began laying out plans for scaling back the huge fiscal support currently provided. The jobs furlough scheme was extended one final time to end-September while taxes will start rising from next year as personal allowances are frozen. Corporation tax will also rise in 2023. Together, these two measures alone are forecast to generate some £65bn in revenue, with more tax rises expected going forward. This suggests a high degree of confidence in the strength of the UK recovery. Contrast this with the EU, where instead of focusing on recovery, officials are instead engaged in working out how to distribute the approximate Eur750bn pandemic recovery fund. The direction of travel between the UK and the EU could not be more different.

A market still underweight sterling

Finally, CFTC data suggests a market relatively underweight sterling. The latest figures (16th March) show net long sterling positions held by the asset management community to be 12,350, compared to 340,470 for the euro. This suggests a pool of untapped potential support for sterling while demand for the euro may already be satiated.

In summary

In summary, the sterling outlook remains positive, the combination of continued vaccinations, lifting of lockdown restrictions and rising yields all converging to support the pound. With the US also appearing to be moving past the worst of the pandemic, but the EU continuing to languish, the pertinent question for a resumed sterling rally might no longer be how high cable could trade, but rather how far Eur/Gbp might fall.

Opinion editorial by Stuart Cole, chief macro strategist at Equiti Capital

‘’This material is provided for informational purposes only and does not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by Equiti Capital. This material is not, and is not intended to be, a “research report”, “investment research” or “independent research” as may be defined in applicable laws and regulations worldwide.

Please see the full disclaimer here: https://www.equiticapital.co.uk/media/11057/disclaimer.pdf ’’

Does The Current Dollar Strength Represent the Start of a New Trend for Cable or Something More Transient?

This weakening has raised suggestions that the outlook for cable was never as positive as the pro-sterling camp was suggesting, that the economic damage from Covid-19 and Brexit had rendered the UK structurally weak, leaving cable vulnerable to trading lower. This raises the question, does cable retain the capacity for further upside gains?

A key issue is whether the current dollar strength represents the start of a new trend or something more transient. The recent rise in yields has certainly provided an unexpected source of dollar support. Predicated on rising optimism regarding the US economy, it would be easy to conclude higher yields will persist going forwards, continuing to underpin the dollar. However, this may not necessarily be the case.

Although the Fed has so far appeared sanguine to this financial tightening, whether it will allow yields to climb significantly higher is debatable. Its view remains that the economic recovery is fragile, requiring support. Higher yields will simply act as a drag on growth, weighing on the booming housing sector, threatening investment spending, keeping unemployment elevated and presenting the Federal Government with an ever-increasing debt servicing cost. Accordingly, there is likely to be a tipping point where the Fed will step in and attempt to take back control of the yield curve, for the express purpose of keeping yields low and in turn seeing the dollar weaken.

A second issue concerns the actual strength of the US recovery. Undoubtedly evidence suggests the outlook is improving, given rising PMI/ISM numbers, stronger retail sales, increasing confidence etc, and February’s employment report very much cemented this narrative. However, the positivity this release generated appeared to overlook the fact that total non-farm payrolls remain over 9 million lower than pre-pandemic levels, with the numbers of long term unemployed actually rising to 4.15mn, the highest level since 2013. This statistic will concern the authorities and until progress is made in reversing it, the Fed will be unwilling to counter a material policy tightening, especially given its view that the labour market will act as a natural dampener on inflation.

Lastly, the Biden Administration has grand spending plans, with a $1.9tn stimulus package ready for dispersal and more spending initiatives in the pipeline. This latest package represents approximately 10% of US GDP and will add to an already large debt stock of some $28tn, and one which is rising fast. Already standing at 130% of GDP, the market is so far showing it retains confidence in the dollar. But at some point, this confidence could wane, potentially threatening the dollar’s dominant role in global finance and almost certainly seeing it trading lower: debt of 160% of GDP was enough to trigger the Greek financial crisis in 2009.

On the flipside to all of this, of course, is the UK, where sterling’s weakness suggests a deterioration in the economic outlook. But this outlook remains upbeat. Progress with covid vaccinations remains impressive allowing lockdown restrictions to be eased, market expectations of interest rates have reversed, Brexit uncertainties have dissipated and plans to reduce public borrowing have been outlined by the Government, suggesting the worst of the pandemic has passed. Overall, a positive picture.

Accordingly, the conclusion is that cable’s losses are largely a US story, the dollar responding too fast to an economic recovery that still poses questions. In contrast, the slower recovery sterling has exhibited towards the improving UK outlook suggests a more solid foundation going forward, one that offers cable a strong base from which to resume its uptrend.

By Stuart Cole, chief macro strategist at Equiti