24 August 2022: BoE unwinding stimulus purchases

GBP – Central Bank to back up hikes with balance sheet cut

The Bank of England is continuing to shrink the size of its balance sheet by selling off assets bought as part of its support for the economy during the Pandemic.

It will sell off £200 million in corporate bonds per week starting next month. As part of its programme of quantitative easing, the Bank bought around £20 billion of bonds from non-financial entities following the Brexit referendum and the Pandemic.

These sales are dwarfed by the ongoing divestment of Government Bond holdings, which are currently being reduced by £40 billion a month. This is being achieved by not reinvesting the proceeds of maturing paper.

The draining of liquidity from the market will add to the tightening of monetary policy which is happening in conjunction with rate increases which have been happening since last December and have been gradually increased in size.

The most recent increase of fifty basis points is expected to be matched at the bank’s next meeting, which will take place on September 15th. The Central bank is still committed to using monetary policy to bring down inflation, despite the lack of evidence so far that the policy is working.

In July, inflation in the UK rose to 10.1% as the cost of staple foodstuffs skyrocketed, driven by the worst drought in Europe for a century and the ongoing conflict in Ukraine. The Bank of England’s latest estimate for inflation sees it peaking at 13.5% which is considered by economists to be significantly below their own expectations.

Following the revelation from Citibank yesterday that they expect inflation to rise to around 18% by the end of this year, other banks have signalled their agreement.

This will ramp up the pressure on short term interest rates, which could rise as high as 7%. This would decimate the housing market, which is already facing a downturn reminiscent of the late 1980s.

Data released yesterday from output across the UK economy showed that services are holding up well, vehicle industry and manufacturing are suffering from both weak demand and shortages of staff. The full extent of the effect of the exodus of EU workers is only now being fully felt following the lockdowns during the pandemic.

The pound received a little lost ground as the dollar saw a bout of profit taking. Sterling rose to a high of 1.1877 having fallen to a new low for the year of 1.1717 earlier. It eventually closed at 1.1836 as volatility appears to be returning after the summer.

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USD – PMIs continue to point to recession

The signs of a slowdown in the U.S. economy are continuing, although the Administration and Central Bank remain convinced that it is not, yet, in recession.

Having seen two consecutive quarters of contraction in the economy, it is becoming increasingly likely that the present quarter will represent a third. The market is faced with the incongruous prospect of the Chairman of the Federal Reserve making a major policy speech this week in which he continues to place the fight against rising inflation at the top of the Central bank’s list of priorities.

It may not be enough to simply say inflation is rising so we need to tighten monetary policy, since the wider economy is slowing at an alarming pace although there has been no follow through in the employment market.

The Fed’s overarching goal is to promote economic growth while keeping inflation close to 2% and to create conditions for full employment. Full employment was once considered to be when the unemployment rate was below 5%.

That has now been lowered, with the unemployment rate now around 3.5%. It has been below 4% now for a considerable time if the anomaly created by the Pandemic is removed.

Apart from the average rate of unemployment, the Fed also considers the participation rate. That is the percentage of the population of labour force age who are either working or actively looking for work. That remains around 62% and remains constant.

Data released yesterday shows that output is falling, particularly in the services sector. The Composite PMI released by S&P Global fell from 47.7 to 45. Anything below 50 denotes a contraction.

While manufacturing continues to expand, the real damage is being done to the services sector, which fell from 47.3 to 44.1.

At his speech at the Fed’s Symposium later this week, Jerome Powell will be hard-pressed to remain as hawkish about interest rates as he has been recently.

It may be that he will signal a slowdown in the size of hikes, although all that has happened so far since the current cycle began in March is that rates have been brought back to a neutral level.

The market may have begun to feel that the time for a pause is approaching and took profit on long dollar positions yesterday. The dollar index corrected to a low of 108.06 but recovered to close at 108.53.

EUR – Higher energy bills see PMIs suffer

The global trend towards lower economic output is also affecting the Eurozone. Data released yesterday showed that overall activity fell from 49.9 to 49.2 in August.

The preliminary data showed that manufacturing saw a slight increase, but in keeping with other G7 nations, it was services that saw the largest fall.

While the fall in output has been moderate so far, the German and to a lesser extent French economies are suffering most. In Germany, the composite PMI fell from 48.1 to 47.6, again driven by services.

Factories across the continent are reporting a steep decline in order books as the prohibitive cost of energy hits demand and the cost of living is hitting consumers hard.

In Germany, businesses suffered their sharpest decline since June 2020. Several European banks are now advising their clients that the Eurozone economy is heading into recession.

There were contrasting stories released yesterday about the energy market.

First, Norway announced that the increase in gas supplies it has been able to achieve as Europe continues to ditch Russian imports can continue at the current level until 2030, while the price of oil rose moderately as Saudi Arabia cut production.

Despite the announcement from Norway, Germany is still facing the prospect of having to ration gas supplies in the winter. It is estimated that the country needs to reduce gas usage by up to 20%, to be able to maintain supply at its anticipated level.

It will be difficult for the ECB to maintain its more hawkish stance on monetary policy, and it may be that once the dust has settled on the current crisis that it is accused of acting too slowly in withdrawing support for the weaker economies.

Inflation is continuing to rise, and the current weakness of the single currency will add to that pressure. Yesterday it fell to a twenty-year low of 0.9900 but recovered strongly to reach 1.0018 before settling back to close at .9963.