GBP/USD

The Bank of England said Britain faces its weakest economic growth in a decade this year as uncertainty over Brexit mounts and the global economy slows, but stuck to its message that interest rates will rise if an EU divorce deal is done.

BoE Governor Mark Carney said "the fog of Brexit" was causing tensions in the world's fifth-biggest economy, and that the risk of an abrupt, economically damaging departure from the European Union was growing.

"There are still as almost as a wide of range of possibilities as there were the morning after the referendum," Carney said after the Bank's policymakers voted unanimously to keep rates at 0.75%, as expected.

Britain is due to leave the bloc on March 29 but Prime Minister Theresa May wants more concessions from Brussels to rally her divided Conservative Party behind her exit plan, which parliament voted against last month.

Interest rate futures indicated investors slightly scaled back their expectations for a rate hike this year. But in our opinion a rate hike this year remained a possibility.

The central bank slashed its 2019 economic growth forecast to 1.2% from a previous estimate of 1.7% made as recently as November. That was the biggest forecast cut since immediately after the 2016 Brexit referendum.

The BoE sees business investment and housebuilding falling this year and a halving of the growth rate in exports.

For 2020, the BoE also lowered its overall outlook to 1.5% from 1.7% before a stronger-than-previously expected 1.9% in 2021.

The downgraded growth expectations coincided with the Bank acknowledging that investors had scaled back their expectations on how much interest rates were likely to rise.

The BoE said that in the run-up to today's announcement, markets were pricing in its Bank Rate reaching 1.1% by the end of 2021, compared with 1.4% at the time of its last forecasts in November.

The BoE sent a reminder to investors that rates might rise more quickly than they expect by saying it saw inflation in two years' time at 2.1%, a touch above its 2% target. The main reason the BoE thinks underlying inflation pressures will build is faster wage growth after Britain's unemployment rate hit its lowest level in more than 40 years. The BoE's wage forecasts were little changed with earnings rising by more than 3% a year over the next three years.

But the bigger picture remains weak. Private-sector business surveys have suggested the economy has slowed to a crawl and the BoE said on Thursday that half of the businesses it surveyed had begun to prepare for a no-deal Brexit.

It repeated its message that it could either cut or raise interest rates after a no-deal Brexit.

Significant rebound out of a 1.2854 low. Long lower wick on today’s candlestick raises the question about potential for a further reversal. A close above 1.2928 will strengthen expectations for a recovery in the coming days. Market once again eyes 200-day moving average, 1.3034.

The MPC voted unanimously to maintain the bank rate at 0.75% at its meeting that ended yesterday, in line with prior expectations. The MPC minutes reiterated that, conditional on a smooth Brexit, further gradual and limited rate hikes are still likely to be necessary to return inflation sustainably to the 2% target. However, the Committee sounded more cautious on the outlook, for two main reasons:

First, since the last MPC meeting in November, the MPC judged that uncertainty over Brexit had “intensified”, reflecting the lack of progress in the ratification process in the UK parliament. Financial conditions in the UK have tightened, more than elsewhere, through higher bank funding costs, higher non-financial corporate credit spreads, and lower UK equity prices. Business surveys (particularly the PMIs) have weakened, the housing market “remained subdued”, and companies had a greater incentive to delay investment. Consequently, the Committee judged that the near-term outlook is weaker than it had expected, and it revised down its expectation for growth in the fourth quarter by 0.1 pp. to 0.2% qoq. And it expects growth to remain around that level in the first quarter of 2019.

The MPC also noted the rise in market-based measures of inflation expectations in the UK, which have diverged from the global picture of lower inflation expectations. In our view, it reflects that market participants are pricing in the likelihood that, in the event of “no deal” with the EU, the value of sterling will likely fall sharply, stoppages and delays at the border will weigh on supply and raise costs and, if the UK government chooses to apply a tariff schedule similar to that of the EU’s, tariffs will rise, all of which would raise inflationary pressure.

Second, the Committee noted that “downside risks to global growth had increased”. In part that’s because of lower global growth outturns than it had expected, and hence less momentum, particularly in the Euro area but – albeit to a lesser extent – in the US and China too. And in part because of a tightening in global financial conditions, which will weigh on global growth ahead.

Reflecting a more cautious MPC, the minutes said, “The MPC judged that the monetary policy response to Brexit, whatever form it took, would not be automatic and could be in either direction”. Previously the MPC had said this about the path for monetary policy in the event of “no deal”, but it now seems to want to introduce two-sided risk (i.e. more optionality) even in the event of an orderly exit.

Overall then, quite understandably and rightly, the Committee is waiting for more clarity on Brexit, which should come in the next three months. If there is an orderly exit from the EU, then we continue to expect the BoE to hike the bank rate by 25bp in May next year; that is, after a couple of months have passed post-March 2019 to confirm expectations of a recovery in business activity. Indeed, the MPC minutes today duly noted the pick-up in wage growth and the positive (but small) fiscal impact on growth from the Chancellor’s October Budget plans – the latter is estimated to add around 0.1 pp to real GDP growth on average over the next three years – which highlights that if it were not for Brexit the BoE would probably be hiking now. In the event of a disorderly exit, the MPC has been at pains to say that monetary policy could move in either direction depending on the move in the exchange rate and the balance of demand and supply, although in reality it would very likely cut rates – at least initially – to support demand.

The Office for National Statistics confirmed a preliminary estimate that Britain's economy grew by 0.6% in the third quarter from the previous three months.

That was the fastest increase since the end of 2016 as consumers spent heavily during the World Cup soccer tournament and a heat wave.

But more recent data suggested growth is slowing sharply ahead of Britain's exit from the European Union, and as the global economy weakens.

Real household disposable income was flat in the third quarter, the second weakest reading since the start of 2017.

Friday's ONS data showed inventories were their highest since the end of 2016, suggesting companies were stockpiling to avoid potential customs delays after Brexit.

Earlier on Friday, private-sector economic surveys showed the weakest consumer sentiment since 2013, and the lowest business morale since 2016's Brexit referendum, as well as the biggest drop in car production since 2009.

Today the Bank of England will publish the MPC decision and the minutes of the MPC meeting. The committee will almost certainly leave the monetary policy stance unchanged. We expect the vote to maintain the bank rate at its current level of 0.75% to be unanimous, as it was in November.

The major reason for the MPC’s wait-and-see position is that the UK economic and political outlook remains clouded in uncertainty over Brexit negotiations. The uncertainty has increased in recent weeks following the delay to the Commons vote on Theresa May’s Brexit deal.

The macro data news since the MPC’s last meeting has been mixed but, on balance, mostly negative. Worryingly, there are signs that uncertainty is weighing more heavily on firms. Business surveys have softened materially – the composite PMI eased to 50.8 in November, its lowest level since the kneejerk slump in the immediate aftermath of the Brexit vote. It points to a quarterly growth rate of just 0.1-0.2%, suggesting downside risks to the BoE’s forecast for 0.3% qoq growth in the fourth quarter of 2018. The one (and arguably only) bright spot is that wage growth has firmed, with regular pay growth rising to 3.3% yoy – the highest pay growth since 2008 as the labor market tightens, in part because of a fall in EU net immigration.

We continue to expect the BoE to remain on hold until Brexit uncertainty lifts.

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