BoE: More easing to come – RBS

James Nelligan, Currency Strategist at RBS, notes that the Bank of England delivered an easing package that was towards the tail end of dovish market expectations.

Key Quotes

“Bank Rate was cut by 25bps and £60bn of QE was announced along with £10bn of corporate bond purchases. A new Term Funding Scheme (TFS) was also unveiled, which is designed to help banks pass on the effect of a Bank Rate cut to the wider economy. In his press conference, governor Carney made it clear that the majority of the MPC anticipate a further cut to Bank Rate this year. However, Carney pushed back against the idea of zero or negative interest rates, emphasising that the lower bound is close to, but a little above zero.

The MPC’s GDP growth forecasts for 2017 moved to 0.8% from 2.3%. The 2018 forecast moved to 1.8% from 2.3%. The downward revisions were driven mainly by capex in 2017 and household consumption in 2018. With the BoE Bank Rate and gilt yields already at historic lows, we expect this easing package to have diminishing marginal returns on the economy.

In our view, the problem isn’t the supply of credit, it’s the demand for credit and more easing will be needed later this year. This may potentially come in the form of looser fiscal policy at the Autumn Statement and/or further Bank Rate cuts (the lower bound is probably 5-10bps).

In the case of the UK, if the BoE hits the lower bound, real rates likely won’t rise because inflation is projected to rise. We forecast headline inflation to rise to 1.5% y/y by the end of 2016. Real interest rates will be falling in the UK, weakening sterling. Previous episodes of BoE QE were a reaction to weak economic data, among other things, and in 2011 cable experienced a relief rally following the announcement of QE.

We believe that sterling will remain weak for some months to come and may be very slow to recover once a base is finally established. Once the elastic between spot and fair value becomes stretched, GBP may gradually recover. This may be driven by a pick-up in FDI inflows as overseas investors pick up more cheaply priced assets in the UK. While this may make the funding of the current account deficit a little easier, the supply side of the economy may be damaged if inflows are limited to private and commercial real estate and productive capital isn’t financed.

Our medium-term target (2y plus) for EUR/GBP is 0.80 and 1.45 for GBP/USD. However, we expect sterling to retest recent lows (Short Cable, target 1.20) before recovery begins. How far it ultimately recovers is a function of the hit to the supply-side. If exit leads to high inflation and lower productivity growth, GBP’s long-term value will be lower. How the current account deficit reacts to recent exchange rate falls will also be important. Deregulation and trade deals, including those with the EU will be important determinants.”