Markets pricing in a cut – deal or no deal - Capital Economics
UK Economics

Markets pricing in a cut – deal or no deal

UK Economics Weekly
Written by Andrew Wishart

While the financial markets are right to expect interest rates to be cut if there is a no deal Brexit, we think they have gone too far by pricing in the possibility that rates will be reduced if a no deal Brexit doesn’t happen. In that scenario, the next move in interest rates is more likely to be up rather than down.

Investors now think the next move in interest rates will be down. The black line in Chart 1 shows the market-implied probability of the MPC cutting rates by the meeting on 30th January has jumped from 27% to 54%. As a result, the 10-year gilt yield fell to 0.68%, below the Bank of England’s policy rate, currently 0.75%, for the first time since the global financial crisis.

Chart 1: Probability of a No Deal Brexit & a Rate Cut

Sources: Bloomberg, Betfair, Capital Economics

Investors clearly expect interest rates to be cut if there is a no deal Brexit. Indeed, the probability of a rate cut priced into the market previously moved in lockstep with the likelihood of a no deal Brexit. (See Chart 1 again.) That makes sense. We think rates would be cut from 0.75% to 0.25% in that instance. (See here.)

But the latest rise in the perceived chance of a rate cut is different. It came despite the chances of a no deal holding steady at about 30%. The upshot is that investors now seem to think there is a one-in-three chance that interest rates will be cut by 30th January even if a no deal Brexit doesn’t happen.

That isn’t crazy. Chart 2 shows that historically the fall in the all-sector PMI in June leaves it consistent with at least a 25bp cut in interest rates. Indeed, we think the economy contracted by 0.2% q/q in Q2. And in his speech on Wednesday, Bank of England Governor Mark Carney acknowledged the risks that the trade war and the slowdown in global growth pose to the economy.

Chart 2: All-Sector PMI & Changes in Bank Rate

Sources: IHS Markit, Refinitiv, Capital Economics

But there are some extenuating circumstances. Wet weather in June was probably behind much of the plunge in the construction PMI, which dragged down the all-sector PMI. (See here.) And we always expected GDP growth to slow in Q2 after Q1 benefited from a one-off boost from stockbuilding. (See here.)

What’s more, if a no deal Brexit is avoided, we think the economy will fare well despite headwinds from overseas. As a result, in contrast to the consensus among investors, we still think rate hikes are more likely than cuts if a no deal is avoided. At the very least, in that scenario rates are more likely to be kept on hold than cut. A closer reading of Carney’s speech suggests the market reaction was overly dovish. Indeed, the Governor said that he found the fall in global rate expectations “a bit extreme”. And he reiterated that if Brexit progresses smoothly the MPC expects the economy to gain momentum, pushing up inflation, and requiring the MPC to respond by increasing interest rates.

It’s worth saying again that if there is a no deal then rates will almost certainly be cut. But if a no deal doesn’t happen, they probably won’t.

Week Ahead

May’s GDP figures, released Wednesday, will give us a better idea of how much the economy shrank in Q2. Later, speeches from external MPC members Silvana Tenreyro and Gertjan Vlieghe might reveal if dovish market sentiment has spread to the MPC.

Data Previews

Monthly GDP & Services Output (May) Wed. 10th Jul.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

Monthly GDP m/m(3m/3m)

09.30

-0.4%(+0.3%)

+0.3%(+0.1%)

+0.4%(+0.1%)

Services Output m/m(3m/3m)

09.30

0.0%(+0.2%)

+0.1%(+0.1%)

+0.1%(+0.1%)

Rebound in monthly GDP won’t prevent contraction in Q2

Despite a rise on the month, GDP growth probably fell from 0.3% 3m/3m in April to 0.1% in May.

Growth in services sector output all but ground to a halt in April. What’s more, retail sales fell by 0.5% m/m in May. But the IHS Markit/CIPS services PMI rose from 50.4 to 51.0. (See Chart 3.) Following a monthly contraction in March and flat output in May, we have pencilled in a small increase in activity.

Meanwhile, industrial production bounced back in May (see the data preview below). Set against this, the construction PMI points to a 0.4% m/m fall in construction output.

Overall, we have pencilled in a rise in GDP of 0.5% m/m. But given the low base in April, that wouldn’t be enough to prevent the three-monthly rolling rate from easing further from 0.3% to 0.1%. And the surveys point to another weak performance in June. We have pencilled in a 0.2% q/q contraction in Q2 as a whole. Of course, this needs to be taken in context with Q1. Over Q1 and Q2, GDP probably rose by 0.2% q/q on average – slower than 2018’s 0.3% but not dramatically so.

Chart 3: IHS Markit/CIPS Services Survey & Services Output

Sources: Refinitiv, IHS Markit/CIPS

Industrial Production (May) Wed. 10th Jul.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

Industrial Production m/m(y/y)

09.30

-2.7%(-1.1%)

+1.4%(+1.0%)

+2.4%(+2.0%)

Manufacturing Output m/m(y/y)

09.30

-3.9%(-0.8%)

+2.3%(+1.1%)

+3.1%(+1.9%)

Car plants to provide a kick

The industrial sector is struggling, but the resumption of car production provided some temporary respite in May.

Surveys of manufacturing output paint a bleak picture. The output balance of the PMI fell from 53.6 in April to 50.3 in May, consistent with stagnant manufacturing output on the month. However, the wont have fully captured the impact of car plants shutting down in April in case there were a no deal Brexit. Similarly, it probably failed to capture the impact of the resumption of car production in May.

The SMMT recorded a 60% m/m increase in car production in May, which should translate to a 35% m/m increase in the official data. (See Chart 4.) Assuming the remainder of the sector stagnated as the PMI suggests, manufacturing output would rise by 3.1% m/m reversing the majority of last April’s contraction.

Looking ahead, though, the further fall in the manufacturing PMI to a seven-year low in June suggests the sector has slipped back into contraction since.

Chart 4: SMMT & ONS Car Production (% m/m)

Sources: SMMT, Refinitiv, Capital Economics

Trade (May) Wed. 10th Jul.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

Trade in Goods & Services Balance

09.30

-£2.7bn

-£3.2bn

-£4.0bn

Trade deficit probably widened, but net trade should still support GDP in Q2

We think that the trade deficit widened in May as weak demand from overseas continued to weigh on exports.

Goods export volumes excluding valuables fell by about 6% m/m in April as the combination of a slowdown in overseas activity and the end of stockpiling ahead of the original March 29th Brexit deadline took their toll.

And it looks likely that the same trend occurred in May. Indeed, the new export orders balance of the IHS/CIPS manufacturing PMI fell from 48.1 to 46.2 in May, which implies another 2% m/m fall in goods exports. (See Chart 5.)

Admittedly, soft domestic demand is likely to have kept a lid on import growth. But we think that the net effect is still likely to have been a widening in the trade deficit. We have pencilled in an increase from £2.7bn in April to £4.0bn in May. But given the surge in imports in Q1, net trade will probably still have added to GDP growth in Q2.

Chart 5: Manufacturing PMI & Goods Exports

Sources: IHS Markit, Refinitiv

Economic Diary & Forecasts

Upcoming Events & Data Releases

Date

Country

Release/Indicator/Event

Time (BST)

Previous*

Consensus*

CE Forecasts*

UK Data Response

Mon 8th

No significant data released

Tue 9th

UK

BRC Retail Sales Monitor (Jun)

(00.01)

(-3.0%)

Wed 10th

UK

GDP (May, m/m(3m/3m))

(09.30)

-0.4%(+0.3%)

+0.3%(+0.1%)

+0.4%(+0.1%)

DR

UK

Services Output (May, m/m (3m/3m)

(09.30)

0.0%(+0.2%)

+0.1%(+0.1%)

+0.1%(+0.1%)

DR

UK

Industrial Production (May)

(09.30)

-2.7%(-1.1%)

+1.4%(+1.0%)

+2.4%(+2.0%)

DR

UK

Manufacturing Output (May)

(09.30)

-3.9%(-0.8%)

+2.3%(+1.1%)

+3.1%(+1.9%)

DR

UK

Construction Output (May)

(09.30)

-0.4%(+2.4%)

+0.2%(+0.2%)

-0.4%(0.0%)

DR

UK

Trade in Goods and Services (May)

(09.30)

-£2.7bn

-£3.2bn

-£4.0bn

DR

UK

MPC’s Tenreyro speaks about inflation

(18.10)

Thu 11th

UK

RICS Past House Price Balance (Jun)

(00.01)

-10%

-12%

UK

Rightmove House Prices (Jul)

(00.01)

+0.3%(+0.0%)

UK

Financial Stability Report (Jul)

Fri 12th

UK

MPC’s Vlieghe on “Challenges facing the MPC”

(09.00)

Selected future data releases and events

Mon 15th

UK

Rightmove House Prices (Jul)

(00.01)

Tue 16th

UK

Labour Market Data (May)

(09.30)

Wed 17th

UK

Consumer and Producer Prices (May)

(09.30)

Thu 18th

UK

Retail Sales Inc. Fuel (Jun)

(09.30)

Fri 19th

UK

Public Finances (Jun)

(09.30)

*m/m(y/y) unless otherwise stated

Sources: Bloomberg, Capital Economics

Main Economic & Market Forecasts**

%q/q(%y/y) unless stated

Latest

Q1 2019

Q2 2019

Q3 2019

Q4 2019

2019

2020

2021

GDP

+0.5(+1.8)

+0.5(+1.8)

-0.2(+1.3)

+0.5(+1.1)

+0.3(+1.2)

(+1.4)

(+1.5)

(+2.0)

Household spending

+0.6(+1.9)

+0.6(+1.9)

+0.3(+1.6)

+0.4(+1.6)

+0.5(+1.9)

(+1.8)

(+1.8)

(+1.7)

CPI inflation (%)

(+2.0) (May)

(+1.9)

(+2.1)

(+2.1)

(+2.2)

(+2.1)

(+2.4)

(+2.2)

ILO unemployment rate (%)

3.8 (Apr)

3.9

3.9

3.9

4.0

3.9

4.0

4.0

Bank rate, end period (%)

0.75

0.75

0.75

0.75

0.75

0.75

1.00

1.25

10 yr gilt, end period (%)

0.71

1.00

0.83

0.92

1.00

1.00

1.25

1.75

$/£, end period

1.25

1.32

1.27

1.26

1.25

1.25

1.30

1.35

Euro/£, end period

1.11

1.17

1.12

1.14

1.19

1.19

1.13

1.17

Sources: Capital Economics, Refinitiv

** Based on a scenario in which Brexit is repeatedly delayed. For forecasts based on a deal or a no deal, please see our UK Economics UpdatePick your own Brexit forecast”, 1st July 2019.


Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com