BOE Likely To Cut... What Comes Next?

| About: Vanguard FTSE (VGK)


Brexit happened.

In response, markets widely expect monetary policy easing from the BOE at the July 14 announcement.

Any monetary policy move--up, down, or sideways--will be. not good. Central bank policy is not a panacea, and the UK will experience a slump regardless of the bank rate.

The ultra-low rate world, set to persist even longer in light of the referendum results, throws markets out of whack: UK equities are up in the face of widespread pessimism.

Throughout the European Sovereign Debt Crisis (which saw precipitous declines obviously in EZ risk assets and CDS spreads, but also in UK equities and business confidence), the BOE held tight and refrained from altering its policy rate. Indeed, of the major central banks' respective responses since the massive crisis-time rate cuts, England's has been, in typical English fashion, the most subdued.

In the below chart, I have circled three recent times when the FTSE 350 (NYSEARCA:VGK) has experienced significant sell-offs. The past two times, there has been no alteration to the BOE target rate.

source: BBG Click to enlarge

But this one is likely to be "the big one," with markets pricing a high probability of a rate cut at the upcoming July 14 bank rate (BOE's policy rate of choice) announcement. BBG has a neat little function that shows implied rate probabilities for different countries, but the screen is messy for the uninitiated, so they nicely summarized participants' bets in the following chart:

source: BBG Click to enlarge

With regards to likelihood of easing, BBG's above chart should speak for itself. But here's the FT anyways:

The Monetary Policy Committee of the Bank of England will formally meet on July 14 for the first time following the EU referendum result and, given the expected negative shock to growth, it is less a question of "whether?" and more a question of "how?" they choose to ease monetary policy.

While the prospect of overnight rates being eased beneath an already extreme and historic low of 50 bps is not comforting, there is some optimism to be found in the yield curve:

Click to enlarge

For some more granular data on expected rate probabilities, here is a matrix of analyst estimates:

Click to enlarge

Let's take a quick look at the FTSE 100. After a brief sell-off immediately following the referendum results, the index is up significantly. Because of the widespread erosion of confidence in the British economy, the decline in growth forecasts, and the significant reduction in the GBP's relative value, it is unlikely that this rise in equity valuations is at all related to the fundamental drivers of stock value. If shares represent claims to economic activity, the recent performance of British stocks is not a vote of confidence in British activity: British equities have done well in spite of the economic outlook, not because of it. What we are seeing is a divergence between actual reality (as approximated by the real economy) and market perceptions of reality. You may wonder what the source is of that divergence. The answer is the yellow line in the graph below: interest rates. A financial asset's valuation is the sum of the discounted future cash flows, and when the discount factors (i.e. BOE's bank rate + some spread) fall, the present value rises. That is what you see at play below. Indeed, the divergence between perception and reality is indicative of the 'bad news is good' dynamic that many market participants and commentators have observed.

Click to enlarge

Thus far I have described a few phenomena, so I will now summarize them succinctly and offer some closing thoughts.

  • Growth prospects have declined significantly since the Brexit decision, and the outlook for the UK is (a) less certain and (b) less positive.
  • The BOE is widely expected to cut rates in order to cushion the anticipated decline in economic activity.
  • Equities, contrary to conventional wisdom that weak growth = weak stock market, have been rising since their initial (fear-based) decline the day of the Brexit results.

Ultimately, the (likely) impending BOE cut, no matter how important (and it is indeed important) is just one more data point in a broad picture of the British, continental European, and world economies. While bank rate carries weight by virtue of its first-order impact, greater changes will, as always, come from the largely unanticipated 1st, 2nd, 3rd, etc. order effects. One important concern, more for the UK than the rest of Europe, is financial services, which in 2014 alone contributed over GBP 140B in value to British gross domestic product. With the BOE pursuing a policy of even easier money, revenue from the net interest spread (running a short book wherein assets have a longer maturity than liabilities, to capture the maturity premium as profit) is likely to decline, which could spell trouble for already embattled European banks. Since 2012, the net interest margin for Eurozone banks (NYSE:DB) (NYSE:CS) (NYSE:C) (NYSE:UBS) (NYSE:RBS) has been sitting at 2 basis points--an absolute pittance.

Is it possible that a flattened yield curve--widely understood to catalyze growth--could actually produce a headwind for the British economy by reducing bank profitability? Only time will tell, but one thing is clear: free, or nearly free money has shown itself capable of disrupting widely held assumptions and correlations. Now more than ever, it will be important to get extremely granular and zero in on how asset prices are determined. As the FTSE 100 performance makes clear, being naive about the math used to price assets is a costly mistake.

Keep an eye out for the July 14th announcement, and let's see where markets go from here!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.