BoE in a bind as outlook continues to deteriorate

GBP: Downside risks for pound with MPC set to cut

Since the start of the second half of this year, the pound has been the worst performing G10 currency and we see no reason for any near-term turnaround in this underperformance. We remain long EUR/GBP as covered in our FX Weekly publication, last published on 25^th July (here). Today, the key macro event is the BoE MPC meeting, which will also include the release of the latest quarterly Monetary Policy Report with updated forecasts. We fully expect the MPC to deliver on the fully priced and widely expected 25bp cut in Bank Rate to 4.00%. The market impact will therefore come from signs of any communication shift and/or changes in the voting composition and to a lesser degree any surprises in the forecasts.

We see the divisions within the MPC being maintained as there has been no dramatic change in the macro backdrop to alter individual MPC members’ thinking on the economy. Hence, like in May when the MPC last cut we could well see a 5-2-2 vote with Huw Pill and Catherine Mann opposing any cut while the two doves – Swati Dhingra and Alan Taylor voting to cut by a larger 50bps. With the MPC still likely divided we see no reason for any dramatic change in the communication from the MPC and hence we expect the key guidance that “a gradual and careful approach to the further withdrawal of monetary policy restraint remains appropriate” will be maintained in the statement.

While inflation has ticked up by more than what the BoE expected in May – 3.6% vs 3.4% - the rate of annual wage growth has slowed a little more than expected and the OIS market shows that expected market interest rates are modestly higher than when the last MPR was published in May. That should be grounds for the BoE showing this pick-up in inflation reversing and that by the two-year and three-year periods of the forecast inflation will be close to the 2.0% target. In May, the projections showed 1.9% for both periods. We would also expect the MPC statement to include the reference relating to the labour market that “a margin of slack has opened up over time” to also be maintained. The jobs data in July for June did revise away some of the labour market weakness but there is enough evidence that the market is loosening.

What we probably won’t hear much about is the deteriorating fiscal position. The NIESR yesterday estimated a huge GBP 51bn fiscal hole that will need filling in order to only get back to having a spare GBP 10bn of headroom. This is a huge requirement and will be politically difficult and would certainly potentially open up scope for the MPC to ease policy more quickly given the disinflationary consequences of such a large tax hike. Such a gap would require a 5ppt increase in the basic and higher rate income tax rates although that’s unlikely. We may get some hints from Governor Bailey about a slower pace of QT ahead with the MPC scheduled to provide details of its plans for the year ahead in September.

We expect the pound to continue to underperform and we see the best avenue to shorting the pound being via the euro. Tax hikes are a certainty in the autumn which is likely already shaping consumer and business behaviour. Greater appetite for savings amongst households and a reluctance to hire and invest by companies seem set to continue. Yesterday, the UK Construction PMI fell to a level not seen since covid (44.3).

UK CONSTRUCTION PMI FALLS TO LEVELS NOT SEEN SINCE COVID

Source: Macrobond & Bloomberg

USD: New tariffs go live but uncertainties will persist

At 12:01am EST the newly agreed tariffs took effect pushing the average effective tariff rate to 18.3% according to Yale University’s Budget Lab, the highest since the 1930’s. But that estimate is unlikely to be stable and will already need slight adjusting higher after the Trump administration doubled the India tariff rate to 50% (effective 27^th August) as punishment for buying Russian oil. After India complained of double standards given China buys more Russian oil than India, Trump hinted that the same could be coming for China. The US trade war truce with China expires on 12^th August so there are risks of fresh increases in tariffs next week. Yesterday, Trump hinted at a 100% tariff on semi-conductor chip imports but suggested carve-outs for companies with investments in the US, like Apple. The carve-outs eased investor concerns but such a tariff level will still prove highly disruptive. Trade policy guidance from the US this week does confirm that while the tariff is now live, goods already shipped and en route up to the 12:01 effective time would not be captured by the new tariffs as long as the goods arrive by 5^th October.

There are also uncertainties related to Japan’s trade deal with Kyodo News citing a US official as stating that Japan’s 15% auto tariff would be stacked on exiting rates rather than 15% being the maximum. Trade negotiator Ryosei Akazawa has denied this but is in Washington seeking clarification.

What is clear from these ongoing developments is that the finalising of these latest tariffs is going to bring very little clarity with uncertainty set to remain high. There is a high risk that Trump may be now pushing beyond the limits of what investors deem tariff levels that bring in needed revenues without doing excessive harm to the economy. With the US jobs market now indicating a much greater potential impact from trade uncertainty, there is a growing risk that investor optimism and/or indifference to Trump’s trade policy begins to turn which will likely see equities suffer and the dollar weaken. The FT’s ‘Opinion Unhedged’ today highlights underlying corporate earnings data that points to slowing corporate profits that we believe could reinforce a shift in investor sentiment and views on Trump’s trade policies

US AVERAGE EFFECTIVE TARIFF RATE LOOKS SET TO GO EVEN HIGHER

Source: Macrobond & Budget Lab, Yale University

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com