Following the surprising decision on July 14th to maintain monetary policy unchanged, the Bank of England is widely expected to cut rates by 25bp at the end of Thursday 4th monetary policy meeting. According to sterling overnight index swap (OIS) rates the probabilities of 25bp rate cut are 98%. A bolder rate cut is not considered possible by markets: the probabilities assigned to a 0.5% rate cut are 0%. The Bank of England could also decide to reactivate the QE program at a pace of GBP25bn per quarter. However, in our view this would be little effect on the economy as Government bond yields are already at historical low levels: the 2 year yield is at 0.14% and the 10 year yield at 0.7%.
The first data released following the UK's decision to leave the European Union (the referendum was on June 23rd) signaled that the impact of Brexit on the UK economy could be huge. For example, the PMI manufacturing index fell from 52.4 to 48.2, the lowest level since early 2013. Rob Dobson, Senior Economist at Markit, which compiles the survey, highlighted that "The pace of contraction was the fastest since early-2013 amid increasingly widespread reports that business activity has been adversely affected by the EU referendum. The drops in output, new orders and employment were all steeper than flash estimates".
The consumer confidence index also fell to the lowest since 2013.
The release of the inflation report on Thursday 4th, with the updated estimates on economic growth and inflation for the next few years, will further sustain monetary policy easing.
We expect a major downgrade from the previous forecast of 2.2% GDP growth for both 2017 and 2018 to below 1% in both years. Indeed, given the rather dramatic comments made by the Governor, there is a risk that 2017 GDP forecast could be close to zero. With regards to inflation, we expect 2017 inflation projection to rise from 1.5% to close to 2% for the Sterling depreciation while 2018 projection should remain unchanged at 2.1%.
Consensus estimate is for GDP growth to decrease from 1.5% in 2016 to 0.6% in 2017 and to rebound to 1.5% in 2018. Inflation should rise by 2.2% in 2017 and 2.1% in 2018.
With Brexit having a negative impact on business and consumer confidence, a weak pound could the only source of growth for the positive impact on exports. Indeed, as highlighted by Markit, "weaker sterling exchange rates aids new export order growth", up in July for the second consecutive month.
In this scenario, we think that the main target of BoE monetary policy will be to weaken the pound, or at least to prevent a strengthening from current levels, in the next few months. We see room for a further devaluation of the pound as, according to OECD' PPP, it is overvalued by 11% against the Japanese yen, by 8% against the US dollar. The pound is undervalued only against the euro: -6.8%.
The need to weaken the pound could pose the BoE in front of a dilemma if a 25bp rate cut would not be enough to ensure a prolonged devaluation. Indeed, cutting the Bank rate to 0% or below could have a negative on the banking sector. The difficult situation of the Euro zone banking sector is a clear example in that direction, even if it is not only the result of negative interest rates.
With the UK banking sector already rescued in 2008 by a GBP400bn government package, it is hard to envisage that the BoE would risk another banking crisis.
For this reason, we think that, following the 25bp rate cut to be decided on Thursday, the BoE would maintain a wait-and-see stance for many months, unless the UK economy would enter in a deeper than expected recession. In this scenario, the pound trend in late 2016/early 2017will mainly depend from other Central Banks' decisions.
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