Thursday, August 04, 2016

BoE Cuts Rates, Adds to QE

The UK's Monetary Policy Committee today announced their first interest rate cut in seven years, lowering the benchmark rate to a record low of 0.25%.  The rate cut came as no surprise to markets worldwide, and the MPC vote was 9-0 in favor of the cuts.  What did surprise some, however, was a £170 Billion stimulus that will be introduced via the purchase of Gilts (UK government backed bonds similar to US Treasury Bonds), the purchase of corporate bonds, and a new bank lending program.  That portion of the stimulus package was not expected to coincide with the interest rate cuts.

The FTSE responded positively to the news, finishing the day up 1.56% although the Pound dropped 1.5% versus the US Dollar and 1.3% versus the Euro.  US markets responded with a yawn, finishing the day flat.  The US 10-Year Treasury Yield, however, dropped 2.58% to 1.51.

BoE Governor Mark Carney sounded a pessimistic note in his presentation, stating, “We took these steps because the economic outlook has changed markedly.  Indicators have all fallen sharply, in most cases to levels last seen in the financial crisis, and in some cases to all-time lows."  That's a bit troubling, given the lengthy duration anticipated for the actual Brexit events to unfold.  With the benchmark rate now down to an extreme low, there is very little additional room for the BoE to maneuver should the British economy slow further.

Surprisingly, the MPC signaled the potential for a further rate cut, although Carney assured reporters that the central bank had no intention of bringing rates into negative territory.  That they would consider - and even signal - that rates could drop to near zero, however, indicates the level of concern the committee has over the economic prospects during the Brexit transition.

The fallout from the Brexit vote has manifested more slowly than critics had forecast, but - at least in the UK - it is starting to be felt.  Consumer Confidence is dropping dramatically, and the industrial outlook is starting to decline as well.  The forecast for the UK GDP is now down to 0.8% for 2017, and the Central Bank foresees a strong decline in corporate investment and in the housing markets.  The Pound's weakness is certainly hurting UK imports, and that is having a marked effect on growth potential over the next 18 months.  That import price pressure is expected to have an impact on inflation in 2017, with the central bank forecasting inflation to hit their 2% target in the fourth quarter of 2017 and exceed it throughout 2018.

What all this signals is a period of weakness, uncertainty, and potential market instability in the UK that will likely last through 2018.  With the ECB taking a bit of a "wait and see" attitude mingled with a healthy dose of skepticism a couple of weeks ago, the likelihood of continental fallout is extremely high.  US 10-Year Treasury yields have declined steadily since December, 2015, and are now sitting at the lows last seen in August, 2012.  That represents a significant flight to safety, and with US equities sitting near all-time highs, it's reasonable to conclude that the heavy demand on US treasury bonds is coming from overseas.

There is a limit to how long the US can remain immune to economic weakness in the UK and the EU.  The strong US dollar is having a severe impact on US exports, and that, in turn has a serious impact on US companies that are heavily exposed to Europe.  This is evident in the behavior of the S&P 500 where demand has fallen off over the past few weeks, and the market has gone essentially flat since it reached a record high in mid-July.  With GDP growth down dramatically in Europe, the UK, and the US, prospects for a global recession are mounting as we transition from a tumultuous US presidential election to the uncertainty of a prolonged Brexit negotiation and execution.

Earnings season in the US is almost over, and there is not another FOMC announcement before September 21.  So now we turn our attention to tomorrow's jobs report.  The pattern in the market right now is not encouraging, so the key economic reports over the next few business days may well set the tone for the remainder of August. 

Happy Trading

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