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Update: Bank of England does just enough
The Bank of England left interest rates on hold at the record low 0.1% and increased the size of its asset purchase programme by £100bn to £745bn. Although largely in line with expectations, the expansion of the QE programme was a little less than some of us had anticipated, and indeed was really the bare minimum to satisfy the market. The BoE said it stands ready to increase QE if required – it may need to this autumn. The Old Lady could have been a little bit braver here and expanded the envelope more.
The Bank said it can conduct asset purchases at a slower pace, and that the programme would be completed by the end of the year, which seems to be taken as a positive for sterling as it implies a degree of hawkishness vs expectations. The lack of any chatter about negative rates also lifted the pound off its lows. But by send time cable was still close to the LOD again – there is a degree of calm about the BoE that is slightly at odds with its major peers like the Fed and ECB. The MPC appears a little too relaxed about all this.
Gilt yields moved higher and sterling rose off the lows. 2yr gilt yields spiked, turning positive at one stage having traded around -0.075% ahead of the announcement. GBPUSD dropped to the lows of the day ahead of the announcement but bounced off lows around 1.2475 to touch 1.2550 before paring gains a little. Cable remains stuck within the recent range between 1.2450 (the 50 per cent retracement of the bottom-to-top rally from the May low to the Jun high.) and the 200-day moving average just above 1.2690 that sparked the run lower since Tuesday.
On inflation, the MPC noted that while the decline in oil prices has been very important in the drop in headline CPI figures, a ‘sharp drop in domestic activity is also adding to downward pressure on inflation’. As a result, inflation is expected to fall further below the 2% target in the coming quarters, largely reflecting the weakness in domestic demand.
On the economy, the MPC thinks the downturn in the second quarter will be less severe than it estimated in May. However, we know that the initial rebound is the easy bit; getting back on the previous trend takes a lot longer.
In particular the Bank seems to be very aware of labour market stress, noting that ‘there is a risk of higher and more persistent unemployment’… and that the ‘economy, and especially the labour market, will therefore take some time to recover towards its previous path’. The Bank will need to cope with a significant increase in unemployment as the year progresses and will require to take more aggressive action.
BlondeMoney Bank of England rate decision preview
BlondeMoney CEO Helen Thomas explains what to watch out for from the upcoming Bank of England policy decision.
Get more top insight from Helen with Blonde Markets every week on XRay.
ECB preview: Welcome to Japan?
The European Central Bank (ECB) convenes next week (June 4th) and is expected to increase emergency asset purchases as it continues to show it will ‘do whatever it takes’. With the scope of the Covid damage becoming a little clearer and deflation rearing its ugly head again, the ECB will stick to the old playbook of more QE to fight it. As ever the market will wonder whether this is ‘enough’, and as ever the answer will come back in the negative.
ECB monetary policy outlook: Japanification?
Eurozone inflation sank to its weakest in 4 years in May, data on Friday showed, only making further expansion by the ECB all the more certain. HICP inflation declined to 0.1% for the euro area, but outright deflation was recorded in 12 of the 19 countries using the single currency. Things have changed a lot since Mario Draghi declared victory over deflation in March 2017.
Nevertheless, core HICP inflation remains stable at 0.9%, which will give some comfort to policymakers. The decline in the oil price passed through to petrol pumps, with energy –12% year-on-year.
Recovery in oil prices should boost the headline reading going forward but the core reading may not be able to withstand the pressures of demand destruction and mass unemployment. The reading today only means the ECB will keep its foot to the floor with increased asset purchases.
However, in reality, given the ECB is already at the absolute limits of monetary policy efficacy, it cannot actually do much about this and only hope that consumer confidence comes back and for energy prices rise – and for global money printing efforts by central bank peers to stoke a round of inflation, which some think will be the outcome post Covid-19.
The concern of course is that Europe, like Japan, has driven itself into a vicious cycle of deflationary tendencies and negative interest rates that will be very hard to escape, particularly as it contends with long-term, perhaps permanent, damage to productivity and economic activity due to the pandemic.
Eurozone economic projections
There will be a lot of focus on the staff macroeconomic projections, although the extreme uncertainty around the extent of damage to the Q2 readings and speed of recovery forecast for Q3/4 means a lot of this remains guesswork.
The ECB has detailed three scenarios for GDP in 2020 relating to the damage wrought by the pandemic: mild -5%, medium –8% and severe –12%. Various comments indicate we can now rule out the mild scenario. Christine Lagarde said this week that the “economic contraction likely between medium and severe scenarios”, adding: “It is very hard to forecast how badly the economy has been affected.”
There is no way of really know how badly Q2 went. We have various sources estimating pretty seismic falls; INSEE says French GDP will contract by 20% in the second quarter. Estimates for Germany suggest a roughly 10% decline.
We know that tough lockdown measures that started to be introduced across Europe in March produced a noticeable impact on Q1. Whilst economic activity is emerging from the cold again as June begins, there is little doubt that April and May saw considerable declines in output.
More PEPP announced after the ECB monetary policy meeting?
The ECB seems all but certain to increase the size of its Pandemic Emergency Purchase Programme (PEPP). The €750bn limit looks likely to run out by the autumn and the ECB will want to push the envelope by a further €500bn.
Germany’s Constitutional Court ruling has obvious repercussions for the Bundesbank, but that ruling relates to ‘normal’ QE and not PEPP, which would tend to argue in favour of expanding this programme now during the emergency, rather than trying to top up later on. Moreover, the ECB wants to make sure that the ‘whatever it takes’ message gets through to the markets to avoid dislocations in bond markets.
Finally, whilst our focus is on the ECB in the coming days, the most important thing for the EZ and the euro is not Ms Lagarde and co, but the frugal four and the EU’s rescue fund. The European Commission’s 7-year budget including the €750bn rescue fund were only published this week so a final decision is not expected any time soon.
Budget talks look set to be long and arduous – the numbers of budget contributors highlight that Sweden, Denmark, Austria and the Netherlands pay their fare share and some: all contribute more than 3% of GDP vs 2.2% by France and 3.9% by Germany. Which is why Germany throwing its weight behind the bailout grants (as opposed to loans) is so crucial. Ultimate the EU will work out a fudge to keep the frugal four on board- the question is whether it can somehow achieve debt mutualisation and make its ‘Hamiltonian’ moment real.
EURUSD chart analysis
The dollar was offered on Friday with DXY sinking to its weakest since mid-March and test the 61.8% retracement of the Covid-inspired rally at the 98 round number support.
This helped push EURUSD higher as the pair cemented the breach of the 200-day simple moving average on the upside. Bulls looking to take out the late March swing high at 1.1150, which could open up a pathway to the 50% long-term retracement at 1.1450.
Are gold prices about to stage a second wave rally?
Gold prices have been very well supported due to a broad flight to safety amid the Covid-19 pandemic, whilst a slump in real yields has made the metal less unattractive despite the lack of inflation.
Although gold swung lower as risk assets were ditched in February and the first half of March, this was prompted by a scramble for cash at all costs due in part to a dollar liquidity squeeze that has since eased considerably.
As risk assets have rallied off the March lows, gold too has made substantial gains and is on the brink of notching fresh multi-year highs. Bitcoin has traded in a similar fashion.
Whilst sentiment and relative dollar values exert short-term pressure, there is one key thing that drives gold prices: real yields. Central banks have been pushing down on yields aggressively with lower target rates and massively increasing their bond-buying programmes.
The Fed’s commitment to unlimited QE and the subsequent messaging from Jay Powell and colleagues means we cannot expect yields to pick up on the front end for some time. In fact we could see them drop further – fed fund futures markets recently priced in negative US interest rates.
Such is the pressure on yields right now that even with a dearth of inflation, real yields are at the bottom of long-term ranges.
Charts: US real yields (10yr TIPS) vs gold prices (inverse)
Moreover, the fiscal response from governments to the crisis could create a wave of inflation, particularly as we can see a pivot to Modern Monetary Theory in terms of a coordinated fiscal and monetary response to the crisis.
Whilst the Covid-19 outbreak is at first a deflationary shock to the economy, and therefore usually negative for gold – which tends to act as a store of value against inflation – the aftermath of this crisis could be profoundly inflationary, and therefore supports the bull thesis on gold.
Given the scale of the indebtedness and the dependency on it, the only option is to inflate it away, perhaps by monetizing the debt and overt monetary financing.
Veteran investor Paul Tudor Jones noted in his recent investor letter the increase in the supply of money (M1) could spur gold to fresh all-time highs.
“A simple metric based on the ratio of the value of gold above ground to global M1 suggests gold could rally to $2,400 before it reaches valuations consistent with the lowest of the last three peaks in this valuation metric and $6,700 if we went back to the 1980 extremes,” he wrote.
On Friday gold tried to stage a break above the Apr 24th peak at $1738 but failed at this level and pared gains. A breach here would call for a retest of the Apr 14th multi-year high at $1747/8. Whilst long-term there is a bullish case to be made, the chart pattern indicates a battle at these levels and a potential triple top reversal pattern set against the bullish flag pattern.