RISK APPETITE IS UP Risk appetite recovered this week, supported by lower market volatility, which had previously risen due to large-scale retail activity, and hopes for the global economy buoyed by vaccinations and fiscal policy support. In the currency markets, reports at the start of the year of the US dollar’s demise seem exaggerated. The greenback may still fall back this year, especially if the global economy recovers, but year to date it has outperformed other G-10 currencies with the exception of the Norwegian krone, helped by stronger oil prices, and the British pound,. The outperformance of the US dollar and sterling seems to be partly driven by the relatively speedy distribution of vaccines in the US and UK, raising hopes of an easing of lockdown restrictions. More than 10 million in the UK have received a first dose of an approved vaccine, with 15 million in the top four JCVI priority groups targeted by the middle of the month and all nine priority groups, including over 50s, by the start of May. The UK government has promised to detail a ‘roadmap’ on the easing of restrictions on 22 February, with schools in England potentially reopening on 8 March (possibly earlier in Scotland and Wales) and speculation that containment measures will start to be eased in the spring.
BOE’S CAUTIOUS OPTIMISM
That cautious optimism was evident in the Bank of England’s new assessment of economic prospects. The economy is now expected to contract in Q1 by about 4% mainly as a result of the national lockdown, but it is forecast to bounce back strongly, helped by the build-up of involuntary savings. Thus, the level of output is projected to return to pre-Covid levels by the first quarter of next year, the same as previously predicted in the November Monetary Policy Report.
Moreover, the forecasts assume the furlough scheme closes at the end of April (as per current government policy), but further measures by the Chancellor, including a possible extension of the scheme, could lower the peak in unemployment which the Bank predicts to be around 7¾% in the middle of this year. On the other hand, there remained uncertainties about the evolution of the pandemic, including new strains, while it is possible that households and businesses respond more cautiously than expected to the opening up of the economy.
Overall, the Bank left policy settings unchanged at the MPC meeting, as widely expected, including Bank Rate at 0.1% and the asset purchase programme size at £895bn. The weekly pace of asset purchases (£4.4bn) was also left unchanged but will be revisited (and potentially reduced) at the next meeting in March. Banks were asked to begin preparatory work for negative interest rates, including a tiered system of reserve remuneration, but policymakers stressed that this was to add that to their policy toolkit and was not a policy signal. In any event, the six-month implementation period of such a policy move means a cut below 0% within that timeframe has effectively been ruled out, while financial markets no longer fully price such an outcome.
Looking at the rear-view mirror, next week’s main UK data is December and Q4 GDP (Wed). We expect the economy to have grown by 1.0% that month, mainly because the national lockdown in England was replaced with local tiered restrictions. That monthly outturn (and assuming no revisions to past data) would result in UK Q4 growth of 0.6%, consistent with Bank of England estimates, markedly slower than the 16% surge in Q3 but remaining positive nonetheless.
REACTING (OR NOT) TO INFLATION RISES AHEAD
Another key theme is whether prospects of rising inflation rates in a number of countries raises speculation about when official interest rates may start to rise. As we predicted, Eurozone CPI inflation jumped up from -0.3% in December to 0.9% in January, according to this week’s ‘flash’ estimate. Admittedly much of that was due to the reversal of Germany’s temporary VAT cut, but it also reflected the upward impact of energy price base effects which will continue into the next few months. The ECB, however, has made clear that the rises should not be confused with a sustained increase in inflation, and that domestic price pressures remain subdued.
Next week’s US January CPI (Wed) is forecast to edge up to 1.5% from 1.4%, but much bigger rises are in store in the coming months mainly due to the energy price component. In the markets, US 10-year Treasury yields have risen towards 1.2% from 0.5% in August, driven by higher breakeven rates. Nevertheless, survey-based measures of inflation expectations appear to be well anchored. The University of Michigan’s consumer sentiment survey, for instance, shows inflation expectations for the next 5-10 years moving higher in January but still below the longer-term average. The February report will be released next week (Fri). In a sign that monetary policy will remain accommodative for now, Federal Reserve Chairman Powell has pushed back as premature on any discussion about a ‘tapering’ of bond purchases.
In the UK, headline CPI inflation is currently 0.6% for December, but the Bank of England’s central projection is for it to be back above 2% in early 2022. We think inflation is more likely to rise towards, but remain below, 2%. As elsewhere, spare capacity in the economy is expected to weigh on domestic inflation pressures for now, while the temporary VAT cut for hospitality is due to end in April. An additional factor for the UK is to what extent post-Brexit trade frictions raise costs in additional to broader increases in global shipping costs, and whether that will be passed on to consumers. That will also be closely watched and assessed by policymakers. Financial markets, though, are currently not pricing in a rise in interest rates (to 0.25%) until 2023 at the earliest.
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None of the information in this article is, nor should be construed as, financial advice. All foreign exchange transactions involve risk and you should always seek your own independent financial advice before entering into any foreign exchange transaction.