30th June 2016
Mark Holman, chief executive officer, TwentyFour Asset Management looks at the options for the Bank of England.
When Mark Carney said that a vote to leave the EU was the single biggest threat to financial stability in the UK, I really think he meant it. However the market reactions that have unfolded, despite being highly volatile, have probably been less severe than he would have expected. His speech at 7am last Friday was factual and timely. There is no doubt that the banking system that he presides over is as healthy today as I can ever remember it, with unlimited liquidity available and capital at levels that are a multiple of what the banks carried into the far more tumultuous events of the global financial crisis. This will certainly have helped calm the market. The big question now is whether he follows up with a rate cut on July 14th?
At the moment, the market is pricing a 33% chance of a cut on this date, a 52% chance of a cut at the next meeting on August 4th and a 70% chance by year end.
We here are somewhat divided on whether he acts in July. One argument is that having made the big statement pre-Brexit, he is almost compelled to act. Adding to this, the MPC will want to be seen to be ahead of the curve as investment in the UK is undoubtedly stalling. On the flip side, with another MPC meeting just 3 weeks later, maybe they will wait to see some early post-Brexit data coming through before they make a decision to lower the Base Rate. After all, with the rate at just 0.5% they do not have a lot of ammo in the gun, so they will want to use it as effectively as possible. Additionally the even lower rates do not really help the banks at this stage.
The MPC (Monetary Policy Committee) will also be very closely monitoring the currency, which has already fallen around 10% and will therefore result in some imported inflation. Whilst the MPC will of course be very focussed on this as it affects their primary mandate, trying to create inflation around the world has been very challenging so the MPC may not be too upset about this side effect. The real worry would be inflation from a currency move that is uncontrollable, such as that in Brazil. However for the world’s 5th largest economy, this is a very small risk indeed. A more realistic comparison is the Euro which was clearly overvalued at close to $1.40 per Euro two years ago, but over the space of the next 9 months it went to $1.05 without importing inflation in any material way. Now, one can clearly argue that the following period had severe shocks to commodity and energy prices which mitigated the inflationary forces, so it is very hard to gauge accurately what impact the big drop in the Euro had on inflation. All things considered though, we don’t think that the MPC will be overly concerned about the move in £ so far.
So where does that leave us on rate cuts? Our view is that they are coming, and that very soon the short end of the yield curve will be very close to zero. The market is probably under-pricing the chances of a cut at 33% in July; we would say it is more like 50% but with an 80% chance of a cut by September.
The cost of credit has however gone up in the UK as the risk premium of Brexit is still firmly in the market, with the cost of bank funding in the capital markets still markedly higher than it was a week ago. This is only natural as we mentioned earlier in the week, as the market hates uncertainty. The risk premium is likely to remain in situ until it becomes clear that a sensible exit to the EU is on the cards, but in the short term that premium could well diminish as the shock of the Brexit and the worst fears subside. So a rate cut, if the banks can pass it on, would not be a bad thing.