Investment Research 06 March 2013 Bank of England preview No QE this time – but still on the table

We expect the Bank of England (BoE) to remain on hold at Thursday’s Monetary Danske Cons. Last Policy Committee (MPC) meeting (13:00 CET). Bank Rate 0.50% 0.50% 0.50% Since the February minutes revealed three members voting for an additional GBP25bn APF 375bn 375bn 375bn of asset purchases, speculations have surfaced about the majority of the MPC shifting Source: Bloomberg, Danske Bank Markets towards restarting the QE programme at this meeting. Comments on a Bank Rate cut have also sparked a debate about the effectiveness of e.g. negative rates.

While acknowledging the existence of the case for more QE with the data coming out

of the UK and euro zone underlining a struggle in the recovery, we do not see the majority of the MPC shifting at this meeting. Nor do we think a Bank Rate cut is the most likely policy change and we think the risks with the current aggressive pricing of the SONIA curve are skewed for the curve to steepen.

MPC will look beyond above-target inflation Since July 2012, MPC policies have been unchanged with the last gilt bought in the Asset MPC forecast of CPI Purchase Facility (APF) in November. Together with the publication of the unchanged 6 6 policy decision at the last meeting, the MPC sent out a statement communicating its view of the appropriate policy response to the combination of the weakness in the economy and 5 5 the prospect of a prolonged period of above-target inflation. The view can be boiled down 4 4 to two points: 3 3 1. The MPC thinks it is appropriate to look through the temporary, albeit protracted, 2 2 period of above-target inflation. The forecasts from the Inflation Report show CPI likely 1 1 to stay above target until Q4 15. 0 0 07 09 11 13 15 2. The MPC stands ready to provide additional monetary stimulus if warranted by the outlook for growth and inflation. Source: BoE Inflation Report, Feb 13

The latter point has been a mantra for most of the second half of 2012 but the newest MPC forecast of inflation above target until Q4 15 (published in the February Inflation Report) has forced the MPC to take a stand on whether it would attempt to bring inflation back sooner by removing the current policy stimulus more quickly than markets anticipate. It has clearly chosen not to. February Minutes surprised with Governor Mervyn King as a minority voter While the unchanged policy decisions at the last MPC meeting were widely expected, it came as a surprise that three members voted for an additional GBP25bn of asset purchases. Governor Mervyn King and Executive Director Paul Fisher both joined Prof. David Miles in preferring to increase the size of the APF. David Miles has been a proponent for increasing the APF since November 2012 and has been a minority voter for four meetings now (see figure 1 below). Analyst Anders Vestergård Fischer +45 45 13 66 41 [email protected]

Important disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com

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Figure 1: Danske Bank Market’s assessment of MPC members and voting for more QE (see appendix for more)

Dove Median Hawk

Prof. Mervyn Paul Charles Ian Paul Dr Ben Spencer Dr Martin David Miles King Fisher Bean McCafferty Tucker Broadbent Dale Weale

8-1 voting: 6-3 voting: Nov-12 -Jan-13 Feb-13

Source: Danske Bank Markets

Governor King’s stand surprised us given his speech on 22 January that ‘Relying on generalised monetary stimulus alone, however, is not a panacea’ and his remarks at the presentation of the February Inflation Report that ‘you can bring it [spending] forward for a period, but you can't go on doing it indefinitely. It's as if you're running up an ever- steeper hill’. Also Paul Fisher’s move came as a surprise to us, as we have not previously seen him vote against the majority of the MPC (see appendix for statistics on voting behaviour). In a speech on 26 February Mr Fisher explained his view in detail, saying he did not believe the assertions of diminishing marginal effect of further QE purchases and that he would suggest the committee take a different dynamic approach to provide monetary support: ‘Rather than a very large, rapid programme of asset purchases to avoid an imminent slump – as was needed in 2009 and again in 2011-12 – a slower, more gradually supportive policy might be more appropriate’. His main suggestion is the art of

open-ended QE where the BoE purchases assets until the economy reaches ‘sustained momentum’. We think the MPC will think hard about entering such a change to the APF

and have not seen any indications from other members nor in the minutes to support this view. Therefore, we do not see this as the most likely policy action in near future.

Discussions of Bank Rate cut

With the appointment of Mark Carney as the next governor of the BoE, media speculation Reprising SONIA curve after release on further policy actions and the monetary framework itself has dominated headlines. of minutes This has also found its way into the MPC and the latest minutes revealed in the MPC 0.70% 0bp examine a wide range of policies, including a reduction in the Bank Rate. However, as 0.60% -4bp has previously been stated in minutes, there exist considerable drawbacks to cutting the 0.50% -8bp Bank Rate, causing a squeeze on bank margins and undoing some of the hoped effect on 0.50% 0.40% +1 -12bp FLS. -3 -3 -7 -6 0.30% -10 -16bp -11 -12 Furthermore, in evidence to the Treasury Committee, MPC member Paul Tucker raised -14 -15-14 0.20% -16-16-16 -20bp the possibility of imposing negative interest rates on a portion of banking reserves as a Mar Aug Jan Jun Nov Apr 2013 2013 2014 2014 2014 2015 way to encourage monetary expansion. MPC member Charles Bean has since the furore Change, rhs BoE dates SONIA Bank Rate 19/02/2013 talked this down, stating that ‘any suggestion that we have a plan to introduce negative Source: Danske Bank Markets interest rates immediately, I should make absolutely clear, is not the case’. When reading below the headlines of Tucker’s suggestion, it seems more like ‘blue sky thinking’ rather than a likely MPC action, which Bean’s statement also shows. Markets have, however, not been prepared for this discussion resulting in flattening in SONIA curve (that now is inverse until January 2014) and a further weakening of Sterling.

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Conclusion: Close call on QE - adjustment of the FLS more likely

The MPC has for some months taken the stance that it would stand ready with more PMIs disagree on direction monetary easing (read: more QE) should the outlook for the economy deteriorate. The question is now whether the majority of the MPC who voted to hold on QE target at the February meeting will reach different conclusions this month. While the surprising drops of two points or more on manufacturing and construction PMIs increased expectations about MPC action, the tendency was not confirmed, with service PMI increasing to 51.8 and sub-components showing positive signs.

The newly published Funding for Lending Scheme (FLS) data showed net lending by participants fell by GBP2.4bn in Q4 following the GBP0.9bn increase in Q3. However, the data show something of a polarisation across participants as the fall was led by Lloyds, RBS and Santander, while a total of 27 other banks have increased their net Source: Macrobond, Danske Bank Markets lending. The MPC still thinks it is too early to gauge the full effectiveness of the FLS, but to the Treasury Committee Paul Tucker expressed his concern about small and medium- sized businesses (SMEs) getting financing. Similar views have been expressed by the Funding for Lending data Secretary of State for Business, Innovation and Skills, Vince Cable. GBP Q3 2012 Q4 2012 Total Our base case is unchanged policy on QE at this meeting. We find it most likely that the Net lending 0.9bn -2.4bn -1.5bn MPC members vote as in February, hence a 6-3 majority for unchanged QE policy. #increasing 29 25 27 Nevertheless, as it only requires two more members to change sides, the risks to this view # decreasing 10 12 11 are present. From our assessment of the different MPC members’ voting behaviour (see FLS drawing 4.4bn 9.5bn 13.8bn - % of eligible 5.7% 16.9% the appendix for details), we do not see Weale, Dale or Broadbent jumping to more QE. Source: Bank of England

This leaves Bean, McCafferty and Tucker in the balance. Our assessment of their attitude towards more QE, mainly derived from their appearance before the Treasury Committee last week, is unchanged from the last meeting. Some adjustment of the FLS towards

SMEs seems more likely, but timing is difficult. Charles Bean said at the Treasury Committee hearing that FLS was different than usual policy tools, as it cannot be changed that easily - so the change has to be the right one. Whether the analysis within the BoE is ready for this meeting is difficult to say, but changes seem very likely within the next couple of months.

In terms of market reaction following the meeting, we can see the risk of a jump in yields if no QE is announced, as this would likely disappoint some market participants. The same arguments apply in the SONIA curve, where we think Dec IMM SONIA still having 15-17 bp rate cut priced in is exaggerated.

A short term reaction on the back of a unchanged policy could put some short term relief to a somewhat downbeat Sterling. On a more strategic horizon we maintain our negative view (see FX Forecast Update, 15 February 2013). We still believe the perfect storm is present driven putting a downward pressure to the currency. This is coming from a combination of an expected weaker USD, further MPC easing still on the table, a dismal growth outlook and inflation to stay elevated over the next two years are all likely to weigh on GBP going forward.

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Hawk Median Median? (new) Median Median Hawk Median Dove Median/ Dove Danske Bank Market’s assessment of members MPC Market’s Bank Danske DrMartin Weale SpencerDale PaulTucker Broadbent DrBen IanMcCafferty Mervyn King Mervyn PaulFisher CharlesBean Prof. DavidMilesProf. Hawk Median Dove Source: Bank of England, Danske Bank Markets APPENDIX:

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