JPMorgan Sonia Signals More QE as Fitch Cuts Rating: U.K. CreditAnchalee Worrachate
U.K. money markets are indicating Bank of England policy makers will step up efforts to stimulate growth by buying another 80 billion pounds ($122 billion) of bonds, according to JPMorgan Chase & Co.
JPMorgan, one of 21 banks that trade directly with Britain’s debt agency, based its calculations on indications of future borrowing costs known as Sonia rates. Bets on further stimulus helped push two-year government note yields to 0.22 percent from this year’s high in January of 0.48 percent, leaving them about the same as U.S. rates. In Germany, the euro area’s struggling economy has helped propel similar-maturity yields to 0.02 percent.
Record-low central-bank interest rates and 375 billion pounds of debt purchases have failed to revive the U.K. Fitch Ratings downgraded the nation on April 19, citing the “weaker economic and fiscal outlook.” Policy makers defeated Bank of England Governor Mervyn King’s push to expand stimulus at three straight meetings as the Monetary Policy Committee grappled with a trade-off between growth and inflation risks.
“There is a need for the Bank of England to do something given the weak backdrop from the euro area and what we see in the U.K., where the economy isn’t significantly recovering,” said Francis Diamond, a fixed-income strategist at JPMorgan in London. The money market rates indicate “a degree of forward looking quantitative-easing expectations. Our in-house model suggests the current level implies around 80 billion pounds of additional QE.”
Traders use derivatives based on the sterling overnight index average, or Sonia, to protect against future changes in interest rates. The contract for next March was at 0.255 percent at 3:10 a.m. London time, below the Bank of England’s benchmark of 0.5 percent, based on Tullett Prebon Plc data. JPMorgan says this difference is due to market expectations for a fresh cash injection because the Bank of England has proved reluctant to cut its base rate since March 2009.
Minutes of policy makers’ April 4 meeting published last week showed King, Paul Fisher and David Miles voted to add 25 billion pounds to the asset-purchase program and were overruled by the remaining six policy makers on the MPC. For the majority, medium-term inflation expectations have “drifted upwards” and more easing may exacerbate this, the minutes said.
In a sign that King’s view may be gaining sway, policy maker Martin Weale said after the minutes were released last week that easing inflation pressures may reduce the barrier to more stimulus.
The five-year break-even rate, a gauge of market inflation expectations derived from the difference in yield between conventional and index-linked bonds, narrowed to 3.03 percentage points today from a high of 3.31 percentage points on April 11, the most since July 2008.
“I would agree with what the sterling money market is implying,” said Robin Marshall, a director of fixed income at Smith & Williamson Investment Management, which oversees about $20 billion. “The MPC may not vote for more stimulus now, but there is a strong case for renewing it. For me, it’s a matter of when and not if.”
Marshall said he’s adding to his gilt holdings, based on the view that the Bank of England will expand asset purchases.
The central bank’s bond-purchase program is designed to support the economy by lowering borrowing costs and encouraging investors to seek higher-yielding assets. It helped push the yield on 10-year gilts to a record low of 1.407 percent in July. The rate was at 1.64 percent today.
The benefits for the economy are less clear. A report on April 25 will show Britain narrowly avoided falling into an unprecedented triple-dip recession in the first quarter, economists said. Gross domestic product rose 0.1 percent in the period after a 0.3 percent decline in the fourth quarter, according to the median of 37 estimates in a Bloomberg News survey.
Consumer prices rose 2.8 percent in March from a year ago, according to an April 16 report, and the Bank of England forecasts that inflation will accelerate to around 3 percent by the middle of the year. Its target is 2 percent.
The unemployment rate based on International Labour Organization methods climbed to 7.9 percent in the three months through February, from 7.8 percent, a report the next day showed. Joblessness rose at the fastest pace in more than a year and pay growth slowed to 1 percent, the least since records began in 2001. U.K. retail sales fell 0.7 percent in March, another report showed last week.
“Something needs to happen to support the economy,” said Alan Clarke, an economist at Scotiabank in London, which is another primary dealer of gilts. “The Bank of England may also look for other alternative tools to do that, but I would not rule out more QE given we have no growth.”
Fitch cut the U.K. by one level to AA+ from AAA last week as it lowered its 2013 growth forecast to 0.8 percent, saying Britain’s debt would climb to 101 percent of gross domestic product in the fiscal year 2015-2016. It became the second firm to strip Britain of its top rating after Moody’s Investors Service did so on Feb. 22. Standard & Poor’s has a negative outlook on the U.K., indicating it may follow.
Investors often disregard changes in ratings. The 10-year gilt yield has fallen 45 basis points since the Moody’s downgrade.
The International Monetary Fund cut its U.K. 2013 economic outlook last week -- forecasting 0.7 percent growth -- and said the Bank of England should consider increasing stimulus.
The IMF also said Chancellor of the Exchequer George Osborne may need to ease the pace of budget cuts. Osborne rejected the IMF’s plea, telling reporters in Washington on April 19 that he had already put in place policies to support the British economy.
The U.K. isn’t the only country where some policy makers have suggested more accommodation may be needed to stimulate the economy. The Bank of Japan earlier this month announced unprecedented stimulus to pull the country out of a deflation quagmire. Three regional Federal Reserve bank presidents --James Bullard, Narayana Kocherlakota and Jeffrey Lacker -- said a further decline in U.S. inflation below the Fed’s 2 percent goal may signal a need for more stimulus.
JPMorgan forecasts that the Bank of England will expand its quantitative-easing program by 50 billion pounds in August and Diamond said it’s unlikely the central bank will be able to do much more, even as money markets signal a greater amount.
“The scope for a huge amount of further QE is quite limited,” he said. “Some MPC members are questioning how effective it is and they are possibly looking for a more effective tool.”