No more QE from the BOE
That was the resounding message we heard from the Bank of England when it presented its penultimate Inflation Report of 2012 last week. Although the Bank revised down the UK’s growth and inflation forecasts for this year and next, Governor Mervyn King suggested that the Bank would wait and see the effects of July’s QE boost and also the Funding for Lending scheme (FLS), the joint venture between the Bank of England and the government that was initiated last month. King said the results of the FLS may not be known until November of this year, conveniently when the BOE presents its last Inflation Report of the year.
The problem is that the FLS is unlikely to be the elixir that is necessary to get the UK lending again. There are a couple of issues with the programme, firstly, it assumes there are enough people and businesses who want to borrow – after all, confidence is low and some people may think that now is not the right time to start that new business or to invest in the new piece of machinery etc. Secondly, there may not be enough high quality borrowers in the UK to make the scheme effective. Post the 2008 financial crisis the emphasis has been on banks to re-build their capital base and only lend to people they know can pay them back. Thus, by encouraging businesses to borrow from banks rather than find alternative forms of finance like small business bond markets etc., may only have a limited impact.
Although King revised down the 2012 growth forecast from 1% in May to 0% last week, he sounded optimistic enough that the dismal 0.7% contraction in GDP reported by the Office for National Statistics (ONS) for Q2 was exaggerating the underlying weakness in the economy. He also blamed the Queen’s Jubilee Bank Holiday for the data and doesn’t believe the economy has got any worse. However, to manage a meagre 0% growth rate the UK needs to see consumption pick up, which has been particularly weak recently. King sounded hopeful that the sharp drop in inflation, CPI in the UK has fallen from 5% to 2.4% in 9 months, could boost household income. However, with oil and food prices both moving sharply higher in recent weeks and months the Governor may have spoken too soon.
The report concluded that the UK’s economic outlook is “unusually uncertain”. Although King did not seem to think that another rate cut would do much to help the economy, expectations are for rates to remain historically low for some time to come. However, for the BOE’s work to bear fruit we may need to see the Eurozone crisis stabilise further and the UK government offer some fiscal stimulus to try and balance the effects of fiscal consolidation. The prospect of either of these things happening remain under debate, hence there were a few signs in the Inflation Report that the BOE has run out of road and there is not much else it can do at this stage.
Next week is jam-packed full of data for the UK: Inflation, house prices and the Bank of England minutes are the highlights. Inflation is expected to fall further from 2.4% in June to 2.3% in July. Producer prices are also expected to moderate further. Weak growth leaves the UK at risk from deflation, and since the BOE is expected to control inflation if prices seriously undershoot the 2% target in the coming months then we may see the BOE alter its current wait-and-see stance and do more QE.
Bank of England minutes are also released next week. Although they are unlikely to tell us anything different from the Inflation Report (growth is weak, but maybe not as weak as what is being reported), it will be interesting to see the split in voting patterns. At the July meeting 7 of the 9 MPC members voted to boost QE with Spencer Dale and Ben Broadbent opting to hold purchases steady. It will be interesting to see if (and how many) members voted for more QE in August, or if King’s wait and see mode is pervading all at the MPC.
The impact of UK economic developments on the pound can be difficult to detect as it has been sloshed around according to overall market sentiment and the Eurozone sovereign debt crisis in recent months. The pound has had a mixed performance; it has been strong versus the euro, mixed versus the dollar and weak versus the commodity currencies. The less dovish stance from King caused GBPUSD to bounce half a cent to above 1.56. The move towards 1.5650 was used as a selling opportunity and GBPUSD went back to moving with overall market sentiment. We are more constructive on the outlook for the pound versus the euro. After getting as high as 0.7960 – the 50-day sma – it sold off after the Inflation Report. It wasn’t only selling off because of fundamental reasons, but also because 0.7960 is a big resistance area for this pair, which caused the bulls to falter. Looking ahead to next week, if sentiment towards Europe continues to deteriorate then we may see a return to 0.780. This would probably need to be accompanied by further weakness in EURUSD.
Europe’s debt crisis no closer to being resolved
Last week was fairly quiet for the Eurozone. There were very few speakers and the continent appears to be in full August holiday mode. As an aside, Italy may be in the grip of a recession and fiscal consolidation cycle, but that did not stop many businesses closing their offices for weeks in August, according to anecdotal reports. Hence there is a sense that the Eurozone crisis seems to be on the back burner. There are no debt auctions or EU summits coming up, and the euro seems to be moved by the (currently) gentle sway of market sentiment.
But don’t get too complacent. The euro may be range bound for now, but there is still some concern about Spain and Italy, which is manifesting itself in the bond market. In this environment it’s worth looking at some of the pillars or rocks in the financial world to get a grip on sentiment. For me that is the bond market. Currently Spanish 10-year yields are at 6.86% (7% is considered the Rubicon line, above which a country may eventually need a bailout). Spreads between Spanish 10-year and 2-year debt are back at more healthy levels as two-year yields have backed away from the 7% level they reached in late July. German bond yields have bounced off their record lows below 1.2% for the 10-year, but they still remain 100 basis points lower than this time last year.
So what does this tell us? Firstly, it says that the Spanish debt crisis may have moved out of the danger zone – as exemplified by the stabilisation in the 10-year – 2-year spread, but the elevated levels of 10-year yields show that bond investors remain on their guard. Indeed, although there has been some selling pressure on German Bunds this has not turned into a torrent and German debt remains an attractive safe haven. So the Eurozone crisis may be on the back burner for now, bank stocks and short term debt levels may have stabilised, but while Spain is still to-ing and fro-ing about applying for a bailout and Germany has not yet ratified the long-term bailout fund, the ESM, then the sovereign crisis could flare up once more taking complacent markets by surprise.
The euro has backed off the 1.2450 highs vs. the dollar that it reached last week as the realisation that the sovereign crisis hasn’t been solved appears to have hit the market’s consciousness. 1.2280 then 1.2160 are major support zones to be aware of in the coming days. 1.2405 is key resistance in the short term – the 50-day sma. We believe that in the absence of much political or central banker speak next week we could be range bound for some time in this pair. At this level the 1.20 June 2010 lows are still in view.
But the plain sailing may not last. September is gearing up to be a major month for Europe and we will be writing much more extensively on this in the coming weeks. The first thing to note is that Greece needs more funds to cover bond redemptions next month. There are also the Dutch elections (where an anti-euro party could garner some support and a lot of headlines). Added to that politicians and central bankers will be back in their offices, this increases headline risks once more. Thus, the next couple of weeks could be a welcome distraction from the seemingly never ending debt crisis in Europe.
Bank of Canada maintains hawkish tone
The Canadian dollar has sustained a break above parity against the US dollar after Bank of Canada Governor Carney delivered hawkish comments. He indicated that the Canadian economy is growing above trend and said this week that the Bank may hike rates if output continues to grow above trend. Recent Canadian data has been strong on the back of a robust housing market. However, the release of the July employment report was somewhat disappointing with an unexpected uptick in the unemployment rate to 7.3% from the prior 7.2%. Moreover, the net change in employment fell by -30.4K vs. expected +6.0K. The drop in jobs was due to a loss in part time employment while full time employment grew +21.3K. Furthermore, due to seasonal adjustments, the July report has typically disappointed market expectations. As such, we would not place too much emphasis on the weaker jobs figures and the overall outlook for the Canadian economy remains relatively upbeat.
In addition to policy expectations, correlated markets such as equities and oil have also supported the Loonie. The S&P 500 currently has a strong inverse relationship with USD/CAD with a correlation of -0.87 (using a 60-day rolling correlation of daily % changes) while crude oil and USD/CAD currently has a correlation of -0.7 Fed expectations sensitive to economic data
When markets increase speculation that the Fed will provide more stimulus, the typical reaction is for dollar weakness, lower Treasury yields, and higher equities. Yields move lower as a monetary easing is intended to reduce borrowing costs and support economic activity, equities generally rally as markets welcome the idea that the Fed is acting to support the recovery, and the USD softens on the anticipation that the Fed will increase the supply of dollars with another round of quantitative easing. On the other hand, reduced anticipation of more Fed accommodation supports the dollar and Treasury yields, and may weigh on sentiment initially as traders readjust their outlook to potential central bank support. As the Fed has indicated its willingness to act if necessary to achieve its dual mandate of price stability and maximum employment, expectations of further accommodation have been very sensitive to economic data surprises.
The economic calendar for the US is busy next week with retail sales, PPI, CPI, housing data, industrial production, and manufacturing surveys. Retail sales have declined for the past three months which underscore declining consumption and economic activity (see figure 4) and we will be watching to see if this trend reverses and retail sales shows growth. Inflation data will be key as price stability is a Fed mandate. July producer prices are due on Wednesday and more importantly consumer prices on Thursday. Recent data has come under increasing scrutiny as markets weigh expectations of Fed action. Treasury yields have backed up with 10-years approaching the 100-day simple moving average (SMA) around 1.74% as labor numbers have shown improvement, however as Bernanke said this week, the economy remains very fragile. As such, data watching should provide clues to the potential policy response. If data continues to show improvement, the Dollar may strengthen on the back of the repricing of QE3. It is also important to note that the USD remains vulnerable to the broader risk environment and may come under pressure should risk sentiment rally.8 using the same metrics (see figure 3). This suggests that a continued rally in equities and oil would help to boost the Canadian dollar.
On previous occasions, Canadian officials have expressed concern as the CAD moved above parity against the USD. This week Gov. Carney said that the currency should reflect Canada’s underlying fundamentals which he described as strong against the rest of the world. Taken together, we think that the CAD has more room to strengthen. Key resistance in USD/CAD is seen around the 1.0100 figure which is where the 100- and 200-day simple moving averages (SMA’s) converge and is likely to be a pivotal level in the week ahead. The 2012 lows around the 0.9800 is seen as a significant support level.
Fed expectations sensitive to economic data
When markets increase speculation that the Fed will provide more stimulus, the typical reaction is for dollar weakness, lower Treasury yields, and higher equities. Yields move lower as a monetary easing is intended to reduce borrowing costs and support economic activity, equities generally rally as markets welcome the idea that the Fed is acting to support the recovery, and the USD softens on the anticipation that the Fed will increase the supply of dollars with another round of quantitative easing. On the other hand, reduced anticipation of more Fed accommodation supports the dollar and Treasury yields, and may weigh on sentiment initially as traders readjust their outlook to potential central bank support. As the Fed has indicated its willingness to act if necessary to achieve its dual mandate of price stability and maximum employment, expectations of further accommodation have been very sensitive to economic data surprises.
The economic calendar for the US is busy next week with retail sales, PPI, CPI, housing data, industrial production, and manufacturing surveys. Retail sales have declined for the past three months which underscore declining consumption and economic activity (see figure 4) and we will be watching to see if this trend reverses and retail sales shows growth. Inflation data will be key as price stability is a Fed mandate. July producer prices are due on Wednesday and more importantly consumer prices on Thursday. Recent data has come under increasing scrutiny as markets weigh expectations of Fed action. Treasury yields have backed up with 10-years approaching the 100-day simple moving average (SMA) around 1.74% as labor numbers have shown improvement, however as Bernanke said this week, the economy remains very fragile. As such, data watching should provide clues to the potential policy response. If data continues to show improvement, the Dollar may strengthen on the back of the repricing of QE3. It is also important to note that the USD remains vulnerable to the broader risk environment and may come under pressure should risk sentiment rally.
