23 March 2017
At long last, after a long campaign, referendum vote, and legal challenges, the Brexit negotiations can officially begin. Of the many important issues confronting the markets will be how the Bank of England navigates monetary policy through these uncertain times. This is especially true as the last CPI release saw inflation breaching the BOE’s 2% threshold, and one MPC member voted for an immediate interest rate hike at the last meeting. As a warning, I am an unrepentant Brexit Remainer, and believe that even assuming a relatively peaceful divorce settlement, leaving the European Union will reduce the nation’s long term growth potential and its political clout, as well as put the future of the United Kingdom at risk. That said, I believe markets are neither anticipating a successful breakup nor a breakdown in talks. Something has to give — the next two years will be interesting!
Recent BOE communications (the February Inflation Report and the minutes of their last meeting) provide a very useful guide to their strategy—and what could alter it– during the negotiations. Despite the criticism endured for suggesting the likelihood of an immediate slump after the June referendum, the BOE clearly intends to pursue a dovish policy stance through the next two years. In particular, the UK central bank continues to maintain a highly accommodative stance even though they anticipate that as result of sterling’s post-referendum depreciation, inflation will not peak until Q2 2018 at 2.8%. Even more importantly, the MPC believes the current “exceptional circumstances” allow it to focus not only on inflation, but also on supporting jobs and growth. Reflecting this shift, the BOE appears willing to tolerate inflation remaining above its 2% for the next three years (the entire forecast period).
However, the MPC cautions about the limits to their tolerance for above target inflation, and provides guidance about what to look out for. During the next three years, the Bank forecasts GDP growth near or below the long term trend, resulting largely from expected weakness in consumer spending. Household spending will suffer, as the rise in inflation resulting from sterling’s depreciation takes its toll on real disposable income. To be sure, capital spending or net exports could pick up the slack. However, the forecast already anticipates that economic uncertainty will produce weak business investment (capital outlays were already down 1% in Q4 2016), and that global growth and sterling’s weakness will boost exports (January trade data show sales abroad rising a healthy 12%).
Lesson 1 – watch the consumer! So far, consumer spending has proved resilient after the referendum. More recently, however, retail sales appear to have declined in Q1 2017. Readings on consumer confidence have been steady, but not spectacular in recent months. While consumer credit and the housing market (house prices nation-wide were up 6% in January) have remained surprisingly solid so far as well. In order to remain comfortable that above-target inflation stems solely from the currency, the BOE will need to see more consistent indications of consumer weakness.
Lesson 2—watch the labour market, especially any sign of accelerating wage growth. Higher pay awards not only would pose a direct risk to inflation, but also would boost household income and spending. To be sure, average weekly earnings have picked up a bit during the past year, but at 2.3% not enough to threaten the BOE’s inflation goal so far. The MPC has consistently over-estimated wage growth during the past several years, and they have concluded that there is more labour market slack than expected. As a result, the Bank now believes the unemployment rate can decline below 4.5% (maybe even 4.25%) – currently at 4.7% — without generating undue wage pressure (in the past, they believed the equilibrium level was around 5%). Furthermore, I believe they view compensation growth of up to 3% to 3.25% as consistent with their inflation target. However, with the labour market tight and likely to tighten further, the conditions appear set for some modest acceleration in wage growth unless the economy slows. Indeed, the BOE is now expecting unemployment to begin to rise. However, if unemployment falls further, especially below 4.5%, the MPC would become more concerned about meeting their inflation goal even over the medium term.
Finally, keep an eye on inflation expectations. So far, both market and survey indicators remain benign, but these can change quickly, and the MPC has highlighted their importance.
Market Impact
To be sure, the future is very uncertain. Inevitably, negotiations will ebb and flow, and markets will be volatile. It would take a brave person to make a precise prediction about the outcome. In general terms, however, either the negotiations will produce an outcome both sidescan live with, or the talks will fail and end in acrimony. Markets are not priced for either outcome. For instance, short sterling contracts are currently discounting one base rate hike in each of the next three years (75bp in total). If negotiations fail, deflationary fears will increase, and the Bank of England might well cut interest rates. On the other hand, if a successful deal (however defined) is achieved, the process of monetary policy normalisation would require more than 3 rate hikes over the next 3 years, especially as UK inflation will remain above the BOE’s 2% target during the entire period.
Investors take your pick! After many years of concern about deflation and advocating extreme monetary accommodation, I find myself in the unusual position of believing that monetary policy will be tightened more than expected. And, despite being a Brexit sceptic, I do believe it is the interest of both the EU and the UK to find a settlement that works for both. With the BOE remaining very dovish, the market’s pricing of one rate hike in the next 12 months is about right (none is also possible). However, the current yield of 0.3% on the 3-year gilt is inconsistent if bases rates rise towards 1.75% during the coming 36 months, if a divorce compromise is consumated.
Since the referendum, sterling has declined 15% against the USD and 11% versus the Euro. I believe the pound is now significantly undervalued versus the greenback: pre-Brexit fair value was about $/£ 1.60, and post-referendum $/£ 1.45. Against the Euro, my fair value estimates are Euro/£1.30 and 1.15 pre- and post-referendum. As sterling is so undervalued versus the dollar, I expect most of sterling’s volatility during the negotiations will occur versus the Euro. Specifically, while some further modest weakness versus the USD is quite likely (another test of 1.20), the undervaluation will limit downside risks to some extent. On the other hand, as Euro/£ is closer to fair value, I expect pound to approach Euro/£ 1.1 during the periods of tense Brexit negotiations that lie ahead.