Morning Commentary: Summer Slowing

Foreign Exchange - Morning Commentary
Summer Slowing
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
The Bank of England will announce its latest rate decision overnight.  Markets are widely expecting the bank to remain on hold as backwards-looking GDP data has been better than expected but forward looking indicators are signaling growing headwinds. 

UK GDP recovered faster than expected through June and July, but this was mainly a result of  fiscal stimulus and an easing of lockdown restrictions that fueled a strong retail recovery.  Additionally, the UK’s job furlough scheme played a huge role in maintaining household income and stopping a sharp rise in unemployment. 

While backwards looking data has been positive, we also need to be conscious of challenges from here.  Chief among these are a drop in fiscal support, rising COVID cases and Brexit risks.  On fading fiscal support, it has been estimated that the government is cutting fiscal stimulus by 70% between Q2 and Q4. 

The government’s “Eat Out to Help Out” scheme that gave government-funded discounts to dine out illustrates the impact of withdrawn stimulus.  Demand for dining out spiked sharply in August but returned to pre-program levels as soon as the scheme ended.  Unfortunately, stimulus not only had few lasting benefits, but it also led to the spread of COVID as stimulus subsidized riskier activities.  This feedback loop is important as risking COVID-19 cases has led to the UK government re-imposing some lockdown measures with the risk of a further rollback of lockdown easing that will hit Q4 GDP. 

Finally there is the issue of Brexit for which risks have risen substantially given recent government action and the continued lack of progress with EU talks.  At present, the best case outcome appears to be a skinny deal with it being a close call on whether a deal or no deal is more likely.  At a minimum, the increased uncertainty will depress investment, hindering growth. 

It is important to remember that the two most plausible scenarios (skinny deal or no deal) are both worse than the BoE’s base case.  This should eventually lead to a more dovish central bank and informs the expectations for further stimulus later this year.  The BoE has repeatedly stated that negative rates are in the toolbox.  However, the bank has also voiced concerns around the practicalities of implementing negative rates and concern that negative rates could hinder credit creation as obstacles to immediate implementation.  This makes increased QE the most likely tool used should the bank decide to do more.
  • Fed forward guidance is in focus at today’s 11 am policy announcement.  The policy rate is widely expected to remain unchanged with the new dot plot expected to show rates near zero through 2023.  Expect Powell to be questioned on how the Fed aims to get inflation sustainably over the targeted 2% to offset for previous undershoots.   
  • US retail sales disappointed at 0.6% versus expectations for a 1.0% rise.  The core reading also missed estimates at 0.7% versus expectations for a 0.9% increase.  Much of the economic recovery, especially consumer spending, is due to stimulus measures including the enhanced unemployment benefit and stimulus checks.  With the US having fallen off a fiscal cliff, August’s retail sales could be one of the first signs of a fade in economic momentum due to a fade in stimulus tailwinds.
  • There appears to be some progress on stimulus talks as a bi-partisan group submitted a compromise package of $1.5 trillion.  This plan splits the difference for enhanced unemployment benefits as well as state and local aid.  Another round of $1,200 stimulus checks with a $500 per child benefit is also included. 
  • The CNY continues to appreciate as the People’s Bank of China (PBoC) set its daily reference rate 0.58% stronger, the biggest such change since April 8.  A record high for the US-China interest rate differentials has attracted elevated foreign flows into Chinese bonds with these flows set to increase further should Chinese bonds win inclusion into another major bond index. 
  • Even if you exclude today’s fix, the PBoC has shown little signs of resisting currency appreciation with the error term on currency fixings neutral despite the recent rally.  This could be reflective of China’s “dual loop” development model that emphasizes domestic consumption.  This policy biases the bank towards less official currency resistance in the absence of overt CNY overvaluation. 
  • The UK could announce additional fiscal stimulus as the government remains under pressure with the upcoming expiration of its jobs furlough scheme.  No details have been given except for the promise to be “creative” in supporting the labor market.
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