BOE’s need to allow the GBP slump to run its course and break the negative correlation to Gilt yields.

The downside risks to the GBP have grown profound and are increasingly being actualised. We looked for 1.20 as an appropriate target for GBP/USD post-Brexit. However, this is far too conservative in light of the growing signs that hard-Brexit is the central scenario and the recent uncertainty over reflationary policy, amid government criticism of Bank of England and signs of a less ambition fiscal stimulus to come in the November statement. The critical thing for the authorities to do is to allow the GBP slide to take its course. The memories of 1992 highlight how self-defeating it would be to focus policy on an exchange rate in contrary to the needs of the economy. A greater concern is the need to reverse the emerging negative correlation between GBP and Gilt yields. This will require the Bank of England to reiterate how its monetary policy framework is intact and to restore confidence in the durability of monetary easing. The slump in the probability of a November rate cut by the BOE to just 8.4% might provide a “lottery ticket” way of positioning for the BOE to make such a statement. However, the uncertainties over the government’s response to the GBP slump means that positioning for further GBP deprecation may, for now, be a cleaner trade than looking for a renewed downtrend in Gilt yields. Indeed, were the authorities to fail to quell speculation that the GBP could become more of a focus of policy, the surge in Gilt yields and associated risk of capital reflux from foreign investors, may only be beginning.

Profound downside risks to the GBP

GBP/USD at 1.20 is far too conservative

Since the Brexit vote, the downside risks to the GBP have grown ever more profound and are being rapidly actualised. We had assumed that 1.20 was an appropriate level for the GBP post-Brexit, which reflected the downside risks to the economy, the imperative for a renewed phase of monetary easing by the Bank of England (BOE) and a risk premium that may be attached to UK risk assets. (The BOE delivers a Brexit ease – now the baton has to pass to fiscal policy.) It also reflected the UK’s vulnerability to a turn in sentiment away from UK assets given the country’s sizable external imbalance, notably a current account deficit that measured -5.7% of GDP in Q2 2016. Moreover, while the UK has a small deficit on its Net International Investment Position amounting to -3% of GDP in Q2 2016, the deficit on the subcategory of portfolio investments measured a far larger -19.5% of GDP, highlighting the potential for large-scale capital reflux. However, the 1.20 target – which was aggressive at the time – now appears far too conservative, and was already breached on a 7th October 2016 “flash crash”.

Chart 1. UK current account balance/GDP

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Source: CEIC

Hard Brexit is now a central scenario

Three factors have substantially added to the downside risks for GBP. Firstly, it seems increasingly clear that a Hard Brexit is becoming the central tendency. As the government prioritises immigration controls, the EEA/ EEA+ (access to the EU in return for limited immigration controls) options no longer appear to be politically viable. The debate at present involves around remaining in the Customs Union or entering into a free trade agreement with the EU, and in both cases hoping that services could be added into the goods based trade arrangement. Such outcomes would naturally increase the immediate adverse economic impact to growth in the form of increased unit business costs (administration, tariffs), and raising the anticipated internal rate of return required to spur investment decisions (due to increased concerns over market access). There is also the simple mathematical issue of reduced immigration lowering actual and potential UK economic growth.

Chart 2. The GBP post-Brexit slump accelerates.

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Source: Bloomberg

The conduct of monetary policy has been questioned

These challenges can be over-come or at least mitigated if there are sufficiently robust and offsetting reflationary policies. However, this is where fresh downside risks to the GBP have been added. A second reason for the GBP collapse was the suggestion by the government that the BOE’s monetary expansion has added to the growing income inequality in the economy by rewarding asset owners. This created concerns that the BOE may be required to focus less on medium-term inflation risks and instead pare back the scale of it’s anticipated monetary easing, and indeed the probability for a November rate cut that had been signalled by the BOE has slumped to just 8.4%. While tighter monetary policy tends to be supportive of exchange rates, this only applies when the policy shift is believed to be sustainable. If a tight monetary policy is viewed to aggravate economic weakness, then the ultimate effect of the policy shift can be to add to medium-term FX downside potential. In addition, markets dislike political influence, however tangential, on the conduct of monetary policy.

Fiscal expansion ambitions appear to be curtailed

A third problem is that the government, while distancing itself from austerity policies, has been scaling back the scale of its ambitions with respect to fiscal expansion. Our view remains that next month’s Autumn statement requires a 2% of GDP fiscals stimulus, but it looks as if a far smaller stimulus will be delivered. These three factors have added to the downside risks to UK economic growth and to the GBP. 1.20, which has already been breached, appears far too conservative a target for GBP/USD. The experience of many emerging market type currency crisis is that when faced with such non-linear risks, exchange rates are prone to wild overshooting and belie attempts to quantify fair value. Unless we see clearer confidence that sufficient policy reflation will be delivered, GBP/USD downside can extend far below 1.20.

 

The need to allow the GBP slump to run its course

The lessons of 1992 – do not fight the currency slump when doing so is contrary to the needs of the economy

The most critical thing for policy-makers in the UK to do is to stay calm and let the GBP slump play out. The worst thing that the government could do is pressure the BOE into trying to stem the slide. While brief and short-tem market smoothing operations are acceptable when liquidity evaporates and moves grow asymmetric and juddering, a more concerted effort to stabilise the currency would be counter productive. The lessons of 1992 to the UK are clear – that defending a currency with overly restrictive monetary policy simply comes at the expense of economic weakness, and with the Brexit uncertainty swirling around the UK the economy does not need another shock. Of course, the BOE knows this. They will – we assume – continue to focus on the medium-term inflation risks to the UK and look beyond the uptrend that higher import prices will have on headline inflation. The risks to medium-term underlying UK inflation remain skewed to the downside. However, government comments on the conduct of BOE monetary policy could complicate the market’s assessment of the outlook for policy and add to the risk premium to GBP, especially since Governor Carney has not yet committed to serving his full 8 year term of office.

Sidebar comment – the UK benefits form G10 countries not having to follow the Washington Consensus

as a brief aside, the required response to the GBP crisis highlights how the Washington Consensus does not apply to G10 economies. When emerging markets are faced with a currency crisis, they are required to stabilise their currency and tighten monetary policy. The key reason for this is the traditional prevalence of foreign debt in emerging markets and how a weaker currency can comprise a tightening of monetary conditions by expanding the local currency debt servicing requirements for domestic firms. The alternative to tighter monetary policy is often debt default or capital controls. This is not an issue in the UK, and monetary and fiscal policy can be focussed on growth.

 

A problem that needs addressing – an emerging negative correlation between GBP and Gilt yields

10yr Gilt yields have surged 20bp this week

One of the concerning aspects of the recent GBP weakness, however, is how it has bled through into higher Gilt yields. In the working week starting Monday 3rd October, a period which encompasses the end of the Tory party conference when Hard Brexit became a central case and a period when the government criticised BOE policies, 10yr Gilt yields have risen by over 20bp to 0.96%. This is a concerning development as it negates the impact of BOE QE.

The negative correlation can be averted if the BOE renews confidence in its monetary policy framework

The trend of higher Gilt yields could easily be extended if there were any reasons for the market to fear that BOE monetary policy will reflect political pressure or adopt a greater focus on the GBP. Two factors comprise particular risks. Firstly, and most obviously, if the market raises it’s assumption of the path of BOE monetary policy, something which is already happening as rate cut expectations are priced out along the OIS, Sonia and Short Sterling curves. Secondly, there could be an asset allocation effect that could expose Gilts more fully to the effect of foreign capital outflows. We have already stated how foreign ownership of Gilts is high at 27% and that the UK has a Net International Investment Position deficit of 19.9% of GDP on debt securities. ( Gilt, the GBP, Brexit and the grudging longs.) However, we also expressed calm at the risk of foreign investors driving a Gilt sell-off. This is because in a climate of weak growth, easier monetary policy and a growing demand for collateral in uncertain times, Gilts would remain appealing components of an investment portfolio. In addition, as long as the BOE did not intervene in the FX markets, any foreign investor that sold their Gilts and GBP exposure would merely sell this GBP liquidity to another financial institution that would have to choose GBP assets to invest in, and Gilts were an appealing location for these funds. (If a central bank intervenes, then the GBP sold by a foreign investor leaves the system, tightening monetary conditions and comprises a net withdrawal of demand for local currency assets). However, the increased concerns over the conduct of monetary policy have complicated this scenario. The market no longer has comfort in the conduct of UK monetary policy. Gilts are therefore vulnerable to capital outflows and domestic asset allocation decisions.

Chart 3. Assuming the BOE demonstrated its analytical framework is undimmed, the on-going Gilt sell-off is likely to be another temporary counter-trend correction.

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Source: Bloomberg

Uncertainty over the government’s response to the GBP slump means that short-GBP is a cleaner trade than fading the rise in Gilt yeilds

This uncertainty over the conduct of monetary policy therefore creates a fresh downside risk to the economy – a negative correlation between GBP and Gilt yields. While a weaker currency is positive for UK economic growth, the effects become baleful when this trend spurs higher domestic interest rates. There is no need for such a correlation to occur. Lower Gilt yields can and should go hand-in-hand with a weaker GBP in the current climate if there is clarity around the conduct of monetary policy. Therefore, what the BOE needs to do is to reinforce to the market that its retains it’s analytical anchor when looking at the UK economy. That it will focus monetary policy on the needs of the economy where it continues to see sizable downside risks to activity. It needs to emphasise that monetary policy will not become focussed on or diluted by GBP weakness. (An unexpected November interest rate cut would go a long way to addressing both of these requirements). This would enable Gilt yields to resume their descent, albeit at the short-term cost of fresh GBP weakness. (As noted above, medium-term the GBP will benefit from a stronger economy). We have not yet altered our medium-term forecast for Gilt yields to move substantially lower. (The BOE delivers a Brexit ease – now the baton has to pass to fiscal policy.) However, the uncertainty surrounding the government’s response to the GBP slump means that the cleaner trade at present may be to retain short-GBP exposure.

Chart 4. UK inflation. Headline CPI has been a poor guide for core inflation

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Source CEIC

The BOE assumes an inflation pass-through of 20-30% of GBP TWI moves

In reiterating the economic framework that drives its policy decisions, the BOE need not be concerned about the inflation consequences of the weaker GBP. The BOE assumes that between 20-30% of a swing in the GBP TWI is transferred to the headline CPI, which currently measures 0.6% Y/Y. That implies that of the 13.6% slide in the GBP TWI since the Brexit vote, the level of the headline CPI will be increased by around 2.7-4.1%. However, the evidence of the post-crisis UK economy is that the pass-through effect is lower than the BOE traditionally assumes, which has sparked fresh research at the Bank into trying to quantify a more accurate pass through effect. In addition, the post-crisis economy has also reinforced the BOE’s decision to look beyond commodity price or FX driven swings in headline inflation. Core inflation in the UK (currently 1.3%) has been relatively insensitive to headline swings, and core determines medium-term inflation risks. The BOE was completely validated in its decision to resist market pressure and widespread sell- and buy-side criticism and refusing to tightening monetary policy in over the past 6 years. The same should apply now.

Conclusion. The need to break the emerging negative GBP/ Gilt yield correlation may keep November a live BOE date

A critical focus for the BOE is to therefore break the nascent trend of negative correlation between GBP and Gilt yields. The best way for them to do so is to reiterate their monetary framework and stress that the outlook for monetary policy remains unchanged despite the GBP slide. This is actually a likely course of action which could suggest that a renewed rally in GBP interest rate markets is near to hand, although the obvious risks is that the government starts to focus on the GBP and stress the need for something to be done. The independence of the BOE allows it to resist any such pressure and to signal clarty over it’s monetary policy. Hence, the 8.4% possibility of a November rate cut seems an appealing risk reward opportunity to position for the BOE to make a statement. The November meeting may be more live that an 8.4% rate cut probability assumes. However, given the uncertainties surrounding the government’s response to the GBP slump, short-GBP positions may be cleaner ways to express the post-Brexit risks rather than a renewed downtrend in Gilt yields. Indeed, were the authorities to fail to quell speculation that the GBP would become more of a focus of policy, the surge in Gilt yields and associate risk of capital reflux from foreign investors, may only be beginning.