UK GDP bounce back the key takeaway from BOE
The pound was a top performer in the G10 FX space on Thursday as the FX market digested the latest information from the Bank of England’s first Monetary Policy Report of 2021. The key messages from the BOE was that negative interest rates are unlikely in the short to medium term, that growth could bounce back sharply later this year and that the pace of the UK’s vaccination programme is critical to the BOE’s forecast. With one in five UK adults now vaccinated against coronavirus, the hope is that life, and the economy, can return to normal by Q2. The relatively upbeat Monetary Policy Report sent GBP higher, however the uptick in stocks was muted, the FTSE 100 was down slightly on Thursday, while the FTSE 250, which is closely linked to the UK economy, finished the day 0.3% higher. The 10-year UK Gilt yield jumped 8 basis points, as the market rushed to price out the prospect of negative interest rates for the UK.
The highlights from the BOE report include:
· UK GDP for the first quarter is expected to fall due to the recent lockdown along with the effects of Brexit and the impact that this has had on UK-EU trade. It is expected to fall by 4% in Q1, which means that the economy may be 12% below its Q1 2019 level. Although the downward effects on GDP are expected to be temporary, the economy is not expected to return to its 2019 size until Q1 2022, which envisages a strong recovery for Q2-Q4 2021.
· The BOE projections are based on some critical assumptions, firstly, that the public will run down 5% of the additional savings that they have amassed during the course of the pandemic.
· The second key assumption from the BOE is that peoples’ fears about their health will dissipate from Q1 onwards, which will continue to have a big impact on the recovery of the UK economy. There is some residual concern at the BOE that people may remain cautious beyond the BOE’s assumed recovery in economic confidence, however, consumer behaviour in the dying days of a pandemic is difficult to predict, so we will need to wait for the economic data to figure out more.
· The third assumption is that business investment grows and that the recovery in GDP is supported by “substantial” growth in government spending. Thus, we do not expect a tightening of the purse strings when the Chancellor, Rishi Sunak, delivers his Budget next month.
· The BOE is also assuming that inflation will remain below the 2% target for the next 2-3 years. Although growth is expected to recover strongly, the BOE is not concerned about a spike in inflation because of the massive amount of spare capacity triggered by the pandemic. Thus, innovation and entrepreneurship could be what steers us out of the economic malaise caused by Covid.
· The BOE wants banks and lenders to be prepared to cope with negative interest rates in the next 6 months, however, they do not expect to use this tool. This is unlikely to be used to defeat the pandemic-induced economic crisis, instead it’s a tool the BOE may have to use for future crises.
Inflation, and when to worry about it
Overall, the GDP forecasts are weaker than they were in November due to the second wave of coronavirus causing another economic lockdown. This was to be expected. It was also expected that the BOE would leave rates unchanged, and that it would not signify any potential change to rates for the foreseeable future. There are two observations about this report that we think it is worth noting. Firstly, that the BOE is not worried about inflation although inflation concerns are rising. Eurozone inflation jumped by the most in a decade last month, and the US yield curve is at its steepest level in 5-years. The gap between the 10-year Treasury yield and the 2-year yield also widened to its largest level since 2017. This reflects the bond market’s expectation for a major reflation trade, as the market awaits an enormous fiscal stimulus package from the new Biden administration. Although President Biden’s stimulus package may not be passed in full, it is still going to be enough to fuel a strong recovery in the US economy, along with Fed support, which could turbo charge the economy, and, potentially inflation, down the line. US Treasury yields have been creeping higher, the 10-year yield is now at 1.14%, up 8 basis points since the start of the week. Treasury yields could move higher in the coming days, however, a break above 1.2% for the 10-year yield is unlikely right now, we do not expect US yields to break this key level until the level of confidence on vaccine distribution is maintained, and there is some assurance that herd immunity can be reached. This means one thing, rising yields are not a problem for policy makers, or stock markets, for now.
Market report
US stocks reached a fresh record high on the eve of the January payrolls report. While blue chip indices did well, the stand-out performer was the Russell 2000, which is made up of smaller companies that are closely linked to the performance of the US economy. This index was up 2% on Thursday and has also reached a record high, as the prospect of fiscal largesse, stimulus cheques and President Biden’s promise of support to “buy American” giving US stocks a leg up compared to the rest of the developed world. We continue to expect US stocks to outperform Europe, mostly due to the slower pace of vaccination in the EU, which could delay economic recovery. The UK is a stand-out performer on the vaccination front in Europe, if it can maintain the vaccination momentum and reopen the economy in March/ April, then UK stocks should outperform their European counterparts in H1 2020.
Overall, there was good news for European banks and oil companies on Thursday. Both Deutsche Bank and Shell announced that they are reinstating their dividends. Considering there isn’t much reason to hold these stocks apart from their dividends, this could spur some fresh interest in these stocks in the coming days.
What to expect from January payrolls
Lastly, it is worth noting that Friday’s payrolls are expected to come in at 50k, up from the -140k in December. However, initial jobless claims fell again for last week and the $600 fiscal stimulus cheques that were distributed in January may have stimulated some short-term hiring. These positive indicators, along with the better than expected employment components of the January PMI reports for the US, suggest that job growth could easily beat expectations. As long as a stronger jobs number is not combined with strong wage growth, only 0.3% growth in wages is expected, then we could see US stocks end the week on an even higher note.