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

Bank of England Holds Rates Steady; Signals August Stimulus

Despite market estimates of an 80% chance for a rate cut today, the Bank of England held rates steady at 0.5%.  With new Prime Minister Theresa May signaling a slow and cautious path towards Brexit and also signaling an invocation of Article 50 no earlier than 2017, the central bank's delay in lowering interest rates makes sense. 

Only 2 1/2 weeks have passed since the Brexit vote, and that is an insufficient amount of time to gather enough data to make an informed projection on the economic climate for the next six to twelve months.  The MPC (Monetary Policy Committee) next meets on August 4th, giving them additional time to gauge the reaction and potential impact.

Additionally, despite the immediate reaction worldwide on June 24 and 27, markets in the UK and around the world have since stabilized and, in fact, rebounded significantly.  In the Forex market, the British Pound did indeed take a significant hit against both the Euro and the US Dollar, however the currencies have since stabilized albeit at the lower levels experienced immediately following the vote.

Given the slight trade imbalance the UK currently experiences, that overall drop in the Pound is actually very good for their exports.  It provides an immediate boost to UK-based corporations and, in that context, is a nice stimulus without the Central Bank taking any actions at all.  Coupled with that, initial fears that companies would seek to relocate out of the UK have since abated.  To that point, JP Morgan Chase CEO Jamie Dimon specified in today's earnings call that he had no intention of leaving the UK despite rumors to that effect on June 24th.  Following the initial shock of the vote, we now see other companies taking a step away from the ledge, realizing that the new dynamic offers tremendous opportunity, not peril.

What the Bank of England has done by standing pat is afforded themselves some options later in the year should the British economy weaken to the point where a stimulus in the form of a rate cut becomes necessary.  Lowering that key rate today would have left the Central Bank with no room left to move as the UK approaches what will certainly be a period of uncertainty after they invoke Article 50.  Remember, the BoE already provided a significant stimulus on July 5th when they eased capital requirements for commercial banks, effectively providing a £150 Billion short-term stimulus.

The change in capital requirements on 5 July was seen as a direct attempt to prevent a repeat of the 2008 crisis in which banks ceased lending.  Whether or not that move is sufficient only time will tell, however as of today the signal is that the MPC is thus far satisfied with the short-term results.

Today's decision underscores a strengthening in the overall financial stability of the UK and stands in stark contrast to some dire warnings issued by Governor of the Bank of England Mark Carney just a week ago: “The number of vulnerable households could increase due to a tougher economic outlook and a potential tightening of credit conditions. In particular there is growing evidence that uncertainty about the referendum has delayed major economic decisions, such as business investment, construction and housing market activity.  The UK has entered a period of uncertainty and significant economic adjustment."  The wording is particularly harsh coming from such a prominent member.

There's no word as to what measures the Committee are considering in August, however according to officials there was significant discussion of it in today's meeting: “Most members of the committee expect monetary policy to be loosened in August.  The committee discussed various easing options and combinations thereof. The exact extent of any additional stimulus measures will be based on the committee’s updated forecast, and their composition will take account of any interactions with the financial system.”

The August 4th meeting comes only a week after the US Federal Opens Markets Committee (FOMC) meets.  Fed Chair Janet Yellen typically addresses the economic environment in Europe and the UK in her post-meeting announcement, so it will be worth listening to that release for clues as to any action the Bank of England may feel necessary.  Given the interrelationships between the various central banks and the global impact each of their decisions have, it would be a mistake to focus only on the MPC for guidance as to what the future economic environment may entail.

Also of interest is the next European Central Bank (ECB) meeting, scheduled for 21 July.  Again, listening to Mario Draghi's perspective will add further insight.  It's likely that, between the ECB and FOMC, we should have a fair idea of the direction the Bank of England may take on August 4th.

Happy Trading.