Bank of England review Easing package, more to follow in November

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1 Investment Research General Market Conditions 04 August 2016 Bank of England review Easing package, more to follow in November As expected the Bank of England (BoE) delivered a substantial easing package today, including a 25bp Bank Rate cut to 0.25%, GBP70bn QE (GBP60bn government bond and GBP10bn corporate bond purchases) and a new Term Funding Scheme (TFS). BoE maintained a very dovish stance indicating a further rate cut later this year to the effective lower bound at above but close to zero. BoE also stressed that it can do more QE (both gilts and corporate bonds) if needed. We expect BoE to cut the Bank Rate by 15bp to 0.10% and to increase its buying of both gilts and corporate bonds at the November meeting. We expect weak GDP growth, monetary policy and flows to weigh on the GBP in the coming quarters. We forecast EUR/GBP to rise to 0.90 in 6M. Longer term we expect EUR/GBP to stabilise to some extent given attractive valuations. We target 0.88 in 12M. Bank of England s easing package 25bp cut in Bank Rate to 0.25%; New Term Funding Scheme (TFS) to reinforce the pass-through of the cut in Bank Rate; Purchase of up to GBP 10bn of UK corporate bonds; Expansion of the asset purchase scheme for UK government bonds of GBP 60bn, taking the total stock of these asset purchases to GBP 435bn. ( utes/documents/mpc/mps/2016/mpsaug.pdf) Source: Bank of England Bank of England s easing package in line with our expectations As expected BoE delivered a substantial easing package today. Overall, the package was very much in line with our expectations, including a cut in the Bank Rate by 25bp to 0.25% from 0.50%, an increase in the stock of purchased assets (gilts) by GBP60bn to GBP435bn from GBP375bn (purchases over the next six months). A new Corporate Bond Purchase Scheme (CBPS) for up to GBP10bn over the next 18 months was announced, so the total amount of QE was GBP70bn (we expected GBP75bn). Finally, a Term Funding Scheme (TFS) was introduced with the aim to reinforce the pass-through of the rate cut. The TFS will provide funding for banks at interest rates close to the Bank Rate. While the Bank Rate cut was a unanimous decision, the MPC voted 6-3 in favour of expanding the asset purchase programme. Kristin Forbes, Ian McCafferty and Martin Weale (his last meeting) all voted against this. This is not a big surprise given their well- known hawkish stance. Their arguments were that it is too early to conclude based on soft indicators, which may overstate the weakness of the economy. Eight members supported the corporate bond purchase scheme (Kristin Forbes voted against). The new Chancellor of the Exchequer, Phillip Hammond, welcomed the easing and said he is prepared to take any step to support the economy. So it is likely that the easing measures from BoE will be supported a by more expansionary fiscal policy when Hammond presents the next budget later this year. By easing BoE confirmed that it puts more weight on growth and unemployment relative to inflation, which was also the case after the financial crisis when BoE held monetary policy accommodative despite inflation being significantly above the 2% target (see chart to the right). Some have argued that BoE should actually tighten its monetary policy as the weaker GBP is expected to push inflation above the 2% target the coming years but the minutes say that BoE judges it appropriate to provide additional stimulus to the economy, thereby reducing the amount of spare capacity at the cost of a temporary period of above-target inflation. BoE sees through above-target inflation Source: ONS, Bank of England Senior Analyst Morten Helt mohel@danskebank.dk Senior Analyst Mikael Olai Milhøj milh@danskebank.dk Important disclosures and certifications are contained from page 4 of this report.

2 We expect the Bank of England to ease again in November As expected BoE said it is on an easing bias and that it can act further along each of the dimensions of the package by lowering the Bank Rate, by expanding the TFS [ ] and by expanding the scale or variety of asset purchases. Also, a majority of members expect to support a further cut in the Bank Rate if data come out in line with the updated projections. In the updated projections, BoE expects growth to decline close to 0% in the second half but to stay positive. We think this is too optimistic. In fact, we forecast a technical recession in the UK with negative GDP growth in Q3 and Q4 16 and hence we expect BoE to ease further in November, when the next Super Thursday takes place (we do not expect BoE to take any actions at the next meeting in September). We expect BoE to cut the Bank Rate by 15bp to 0.10% and to increase both APF and CBPS at the November meeting. Note that BoE has said explicitly that the new lower bound is close to but above 0% and ruled out negative interest rates. At the press conference, BoE governor Carney said he is not fan of negative rates and prefers other measures. BoE GDP growth outlook too optimistic in our view, more easing to follow Source: ONS, Bank of England, Danske Bank Bank Rate cut to 0.1% priced for November Yields inched lower across the Gilt curve and the 2Y10Y Gilt yield curves flattened 8bp on the announcement and a cut in the Bank Rate to 0.1% is now fully priced for November. In the FX market, the GBP weakened slightly versus the EUR and USD, with EUR/GBP trading nearly 1.5 figure higher compared to before the announcement. The relatively (in spite of the size of the easing package) limited increase in EUR/GBP is fair given that the package was largely priced in the market. Our short-term financial models also imply that the increase in EUR/GBP is fair given the decline in UK interest rates and EUR/GBP continues to trade very close to the model s fair value estimate of (spot ref.: ). Bank Rate cut to 0.1% priced for November EUR/GBP trades spot on fair value according to Danske Bank s shortterm financial model 0.30% 0.25% 0.20% 0.15% 0.10% 0.05% 0.25% GBP/OIS forward market 0.00% Aug16 Nov16 Feb17 May17 Aug17 Current Live Policy Rate Source: Danske Bank Markets Source: Bloomberg, Danske Bank Markets GBP outlook: relative growth, monetary policy and flows to weigh on the GBP In the short term, we expect the BoE s very dovish stance to continue to weigh on the GBP. We target EUR/GBP at 0.86 in 1M. In the medium term, we expect weak growth and subsequent monetary easing to weigh further on the GBP. We are more negative on UK GDP growth in H2 compared to BoE and we expect negative growth surprises to support pricing of additional QE in the coming months. Moreover, we think that the substantial current account (CA) deficit of around 5% of GDP in the UK combined with high uncertainty about near-term FDI and portfolio flows into the UK warrant further GBP depreciation. We forecast EUR/GBP at 0.88 in 3M, 0.90 in 6M. UK s significant current account deficit to weigh on GBP medium term Source: Macrobond Financial, Danske Bank Markets 2 04 August

3 Longer term we expect the GBP will stabilise to some extent given attractive valuations. With EUR/GBP at 0.90, both our MEVA and PPP models suggest that the GBP would be significantly undervalued with a close to 2 sigma deviation from fair value estimates of and (MEVA and PPP, respectively). We target EUR/GBP at 0.88 in 12M. G10 MEVA model implies that EUR/GBP is not yet significantly overvalued Forecast: 0.86 (1M), 0.88 (3M), 0.90 (6M) and 0.88 (12M 0.95 EUR/GBP Source: Eviews, Macrobond Financial, Danske Bank Markets Aug-15 Nov-15 Feb-16 May-16 Sep-16 Dec-16 Mar-17 Jul-17 75% conf. int. 50% conf.int. Forward Danske fcst Consensus fcst k EUR/GBP 1M 3M 6M 12M Forecast (pct'ile) 0.86 (72%) 0.88 (81%) 0.90 (83%) 0.88 (69%) Fwd. / Consensus 0.85 / / / / % confidence int / / / / % confidence int / / / / 0.94 Source: Bloomberg, Danske Bank Markets 3 04 August

4 Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ( Danske Bank ). The authors of the research report are Mikael Olai Milhøj, Analyst, and Morten Thrane Helt, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high-quality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including a sensitivity analysis of relevant assumptions, are stated throughout the text. Expected updates None. Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research has been prepared by Danske Bank Markets (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change, and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided in this research report. This research report is not intended for, and may not be redistributed to, retail customers in the United Kingdom or the United States. This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank s prior written consent August

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