GBP/USD

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.

EU reached a deal with Italy

The European Commission reached a deal with Italy over the country's 2019 budget that avoids an EU disciplinary procedure against Rome, Commission Vice President Valdis Dombrovskis said. He added the decision could be revised in January if Rome did not fully apply the agreement reached with Brussels. Under the compromise, Italy has lowered its headline deficit for next year to 2.04% of output from 2.4% it had planned earlier.

The more important structural deficit, however, which excludes one-off items and business cycle swings, will not change in 2019 from 2018 levels. Under EU rules, Rome was supposed to reduce the structural deficit by 0.6% of GDP, but instead proposed in its original 2019 draft budget an increase of 1.2% according to the Commission. The compromise at zero change was not ideal, Dombrovskis said, but allowed the Commission to drop plans to start disciplinary action that could end up in fines.

Slowdown in UK CPI

British consumer prices rose at an annual rate of 2.3% in November, the lowest since March 2017, in line with market consensus and down from 2.4% in October.

The biggest monthly fall in petrol prices in more than three years was the biggest driver of slower consumer price inflation, reflecting a sharp fall in the cost of a barrel of oil.

British consumers have been pressured by inflation since June 2016's Brexit referendum triggered a fall in sterling. A year ago, inflation peaked at a five-year high of 3.1%.

But despite the fall in inflation since, and a pick-up in headline wage growth to its highest in a decade, businesses have reported a downturn in consumer spending in recent months.

The British Chambers of Commerce forecast on Tuesday that economic growth this year and next would be the slowest since the country was last in recession in 2009.

Earlier this month the Bank of England sketched out a worst-case no-deal Brexit scenario in which sterling would plunge to parity against the U.S. dollar, inflation would exceed 6% and the economy contract by 8%.

Fed to raise rates and lower rate projections

The Fed will likely raise its target rate by another 25bp to a range of 2.25-2.50% today. This would be the fourth hike this year, the most since 2006. The interest paid on excess reserves, IOER, will most likely be raised by only 20bp in order to bring the effective fed funds rate back to the middle of the target band.

The updated Summary of Economic Projections should show similar economic and inflation projections for the coming three years to those forecast in September. The FOMC members’ rate projections, however, will likely be lowered and indicate a shallower path than before. In particular, we expect the dots to signal only two hikes for 2019 (down from three), and the dots for 2020/2021 might each come down by 25bp as well. The main reasons for the more cautious rate outlook are, in our view, tighter financial conditions as well as concerns about the outlook.

U.S. President Donald Trump has repeatedly berated the Fed and on Tuesday said in a Tweet it was "incredible" for the central bank to even consider tightening given global economic uncertainties.

Comments by Fed Chairman Jerome Powell in late November that the key interest rate was “just below” neutral, a level that neither brakes nor boosts the economy, have bolstered investor expectations that U.S. central bank is nearing a pause on its monetary tightening.

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