Bank of England may have no choice but to join race to the bottom
It has been one of those rollercoaster weeks for markets. Expectations have taken a turn for the worse. While most fingers would, justifiably, point to trade tensions, central banks’ actions have played a key role. Instead of being a force for calm and reassurance, they seem to have sent the opposite message to markets and investors. All of this discord presents the Bank of England with a peculiar problem.
Last Wednesday probably highlighted this in the best (or worst) possible fashion. Three central banks — in New Zealand, India and Thailand — cut interest rates by a combined 110 basis points. The Reserve Bank of New Zealand was particularly aggressive with a 50 basis-point cut.
Moves of this magnitude are normally reserved for recessionary periods. Yet, our growth forecasts for these three economies this year are 2.3 per cent, 6.7 per cent and 3.1 per cent, respectively. The UK chancellor would be very envious of such numbers — our forecast for UK gross domestic product this year is all of 1.1 per cent. But instead of welcoming the stimulus, markets concluded that these central banks may be considerably more pessimistic about their own economies, and the world, than current numbers would suggest. Be that as it may, if we set aside Brexit considerations for a moment, the BoE should for now be comfortable on the sidelines of the race to cut rates.
First, it is important to consider what rate cuts in general truly achieve. In emerging markets, the main transmission channel is the exchange rate. Lower interest rates reduce the attractiveness of the carry trade — whereby investors borrow in a low-yielding currency to buy higher-yielding assets in another — though they may improve the balance of payments by boosting export values and cutting import demand. For the UK, even without rate cuts, idiosyncratic factors have already led to material weakness for the pound. While we do expect sterling to recover in the medium term, any stimulus from the currency at present is certainly welcome and raises the bar for rate cuts. We will need to keep an eye on imported inflation.
Second, the BoE probably does not need to worry too much about what the renminbi is doing, but Thailand, New Zealand and, to a lesser extent, India certainly do. China is the biggest export destination for both Thailand (with a 12 per cent share) and New Zealand (a 25 per cent share). The recent devaluation of the Chinese currency, with a clear indication that further weakness is on its way, would not have gone unnoticed. Chinese demand is expected to fall as imports become more expensive, so exporters to the country had no choice but to react. China accounts for barely 4 per cent of UK exports, most of which is in services, which are arguably less sensitive to exchange-rate movements. What is next for the dollar and the euro is much more important to BoE decisions.
This brings us to the final matter at hand: the Federal Reserve. We expect an additional 50 basis points of easing by the end of the year and more to come next year. Markets may expect even greater policy accommodation and this will pressure the dollar. We must also bear in mind the prospect that the White House may actively choose to become more forceful on the exchange rate. The dollar itself is the remit of the US government (through the US Treasury) rather than the central bank, so tweets on the matter may need to be taken a bit more seriously.
For now, the prospect of the US starting a dollar-based “currency war” is remote; Washington will be fully aware of the risks and disruption that would bring. A more likely scenario is that the Fed itself will acknowledge that dollar strength is constricting financial conditions in the US and act accordingly. The European Central Bank may reply in kind.
Even under a very benign Brexit outcome, the UK as an open economy will feel the adverse effects of global monetary trends. If the Old Lady of Threadneedle Street suddenly finds herself becoming the centre of markets’ attention, she might have to reluctantly head to the track for the policy race to the bottom.
Geoffrey Yu is head of the UK investment office at UBS Wealth Management