Inflation Report this week. Inflation Report .. Governor warns of greater monetary tightening. The MPC voted 7 -1 to hold the bank rate at 0.25%, maintain the stock of government bonds at £435 billion and to maintain the purchases of corporate bonds at £10 billion. Good to know the Bank is easing borrowing costs for the likes of Apple Inc, with a market cap of $800 billion and cash reserves of $250 billion. Excellent!
The Old Lady's corporate bond purchases are an indicator of the drift in policy away from market reality. The UK corporate bond market is one of the few remaining investment niches in the investor search for Alpha. Valued overall at around £130 billion, best for the Bank to stay out. Otherwise the MPC will create the biggest "corporate bond bubble in history", just as has been done with gilts.
So why are rates on hold? The Bank has adjusted the forecast for growth in the current year to 1.9% from 2.0% in February. It is a modest adjustment. A mere typo in publications from the Office for National Statistics. The Bank remains concerned about the prospects for household spending given rising inflation and the slow growth of wages. Inflation is set to peak towards the end of this year at just under 3%. Earnings are set to rise around 2%, hence the arithmetic squeeze on real incomes.
The good news, slowing household spending will be offset by growth in investment and net trade. Business surveys and bank agents reports, imply that investment growth will be higher in 2017 than previously expected. The bank also believes that stronger growth in world trade and a weaker sterling will lead to an improvement in the net trade balance.
Growth in world trade will lead to an increase in imports, this is true. The problem is exports have a high degree of import dependency. There is little or no substitution effect from sterling weakness. The growth in investment may well hold. The trade deficit (goods) will increase to over £140 billion this year.
So what of growth? Growth in the first quarter was around 2.4% according to the preliminary estimate of GDP released at the end of April. The latest data for manufacturing and construction confirm our Q1 estimates of GDP growth. The portent for a larger trade deficit is also confirmed with an ominous rise in the first quarter trade gap.
So what of rates? The Governor warns that if "the economy follows the path broadly consistent with the May projection, then monetary policy could need to be tightened by a somewhat greater extent than the yield curve would currently imply". And that is about as hawkish as the Governor has been for some time! Kristin Forbes was the only member of the MPC to vote for a rate rise this month. If the data unfolds as we expect others will be set to follow ...
In other news this week ...
The trade deficit in goods increased to £37 billion in the first quarter. This compares with a shortfall £32 billion in the same period last year and in the final quarter of 2016. For the year as a whole we project a trade in goods deficit on £144 billion compared to £134 billion last year. So much for the ephemeral benefits of sterling depreciation, as we have long explained.
Growth in Europe and the rest of the world will stimulate demand for exports. Domestic growth and a high dependency on imports will compound the trade balance deterioration. The deficit in goods was offset by growth in the service sector surplus of £26 billion. The service sector, particularly tourism, enjoys much higher price elasticity [than goods] and profits from world growth. The overall trade in goods and services deficit for the year as a whole is likely to be over £45 billion compared to £37 billion last year. As the deficit moves to 2.5% of GDP, the Bank of England will be forced to review the accommodating monetary stance before markets force the call.
Manufacturing growth increased by 2.3% in March and by 2.5% in the first quarter of the year. Construction growth increased by 1.8% in the same period. It's a "mixed bag". New housing was up by 4.3%, Commercial real estate growth was up by 7.3%. Infrastructure spending was down by 4.2%. Industrial building was down by 18%. The overall data for manufacturing and construction were in line with the preliminary GDP estimates. There has been no change to our outlook for the current year. We still expect growth to be between 2.0% and 2.4%. Strong growth, rising inflation and maturing trade gap ... time to tighten by a somewhat greater extent!
So what happened to Markets?
The Dow closed at 20,919 from 20,944. The FTSE closed up at 7,386 from 7,297.
Sterling was down against the Dollar to $1.289 from $1.296 and was up against the Euro to €1.186 from €1.179. The Euro moved down against the Dollar to 1.086 from 1.099.
Oil Price Brent Crude closed at $50.77 from $48.96. The average price in May last year was $46.74. The inflation impact fades into the second quarter of the year.
UK Gilts - yields moved up. UK Ten year gilt yields closed at 1.15 from 1.12. US Treasury yields moved up to 2.38 from 2.36. Gold closed at $1,224 from $1,225.
That's all for this week. Don't miss our economics update at PwC Manchester on the 18th May. It's usually a sell out so make sure you book now! As always we appreciate your support. "Join the Club" for those special insights into currencies and markets. Your support will boost our research and improve the products we offer.
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