Market Outlook - BNP PARIBAS - Investment Services India

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esume purchases should market conditions or the recovery in the macro economy take a turn for the worse. When will the first hike be? In the past, extrapolating the BoE’s inflation projection and judging when it will exceed target has been a good guide to when the first hike will arrive. Typically, the first rate hike should be expected to be roughly two years before inflation is projected to exceed target. On the basis of the likely projection in the upcoming Inflation Report, one could argue that the first rate hike is not very far off. That point could be as early as Q3 2010, since extrapolating the Bank’s projection will probably see inflation above target by Q3 2012. However, this overlooks one crucial factor. The Bank’s projections take no account of the fiscal tightening that is likely to be announced in the aftermath of the general election. This is normal practice for the BoE. If the projections did include such tightening, the Bank’s GDP growth projection wouldn’t be anywhere near 4% in 2011 and the inflation projection would be somewhat lower. We judge that this means the first rate hike is unlikely to be delivered until at least early 2011. However, by that point we expect GDP growth to be significantly weaker than the Bank is expecting and for inflation to be on a steady downward trend below target. We believe these will contribute towards an even longer delay before hikes begin. Emergency rates no longer necessary? We are often asked whether the BoE may consider moving Bank Rate from an “emergency level” to a level that is just “very low”. After all, the emergency appears to have passed. However, 0.5% Bank Rate is not what it seems. Very few borrowers are fortunate enough to be paying interest on borrowing anywhere near Bank Rate. Chart 4 shows the average mortgage rate paid by households (which takes account of how many borrowers are on fixed rates and which maturities as well as variable rates etc) against Bank Rate. When Bank Rate peaked at 5.75% during 2007, the average effective mortgage rate was a mere 20bp above Bank Rate. Since the financial crisis began, that spread has blown out to around 300bp such that the average mortgage rate paid is just above 3½% despite Bank Rate being only 0.5%. Similarly, although the spread between corporate bond yields and gilts has compressed since the height of the financial crisis, the spread remains around 160bp wider than pre-crisis levels (which were on average around 100bp). Chart 3: Lending to Corporations Source: Reuters EcoWin Pro Chart 4: Bank Rate vs Average Effective Mortgage Rate Source: Reuters EcoWin Pro The deputy Governor of the RBA in a recent speech noted the RBA may not have to raise the policy rate by as much for this very reason. The spread between market rates and the policy rate meant that the current policy setting was around 100bp tighter than would otherwise have been the case. Furthermore, since potential GDP growth in the UK is now around 100bp lower than before the crisis, this means that neutral interest rates are that much lower than they used to be (3.5-3.75% instead of 4.75%). The point is, in isolation, Bank Rate at 0.5% looks incredibly low. However, taking on board the tightening delivered by the market, the policy setting is much less accommodative. Add to that the likely rise in gilt yields once QE ends and the policy setting will tighten even without the help of BoE hikes. Conclusion We expect the BoE to pause its asset purchases at the February meeting. While the Inflation Report projections may entertain speculation that the first rate hike is not that far off, we believe that would be the wrong interpretation and the first rate hike is still a long way away. Alan Clarke 29 January 2010 Market Mover 14 www.GlobalMarkets.bnpparibas.com
UK Inflation: Bridging the Gap • In the past year, core inflation rates in the UK and eurozone have diverged significantly. Chart 1: Headline CPI – Eurozone & UK • Core inflation in the eurozone is close to its all-time low – in the UK it is at an all-time high. • The sharp rise in UK inflation has been a core goods phenomenon. • Sterling’s weakness appears to be playing a role, although it is second-hand car prices that have driven the bulk of the increase. • In contrast, and comfortingly for policymakers, services prices do appear to be responding to the weakness of economic activity in the UK. Source: Reuters EcoWin Pro Chart 2: Core CPI – Eurozone & UK Core divergence The contrast between the inflation data in the UK and eurozone over the past twelve months has been stark. Not so much at a headline level – both have been pulled down and then up by exceptionally large commodity price base effects (Chart 1). Rather, the real divergence has been in core inflation (Chart 2). Despite the sharp economic downturn, and a pretty tepid recovery to date, core inflation has been trending higher in the UK. Over the past year, it has risen by nearly 2pp, reaching 2.8% y/y in December. That increase is exaggerated by a VAT cut at the end of 2008. But December 2009’s 2.8% core print still compares unfavourably with the near 2% inflation rates that existed in the months before the VAT cut. Source: Reuters EcoWin Pro Chart 3: Core Goods Inflation In contrast, core inflation in the euro area has been trending down. Having started 2009 at nearly 2% y/y, eurozone core inflation finished the year at 1.1%, just 0.2pp shy of its previous all time low. The result has been a widening of the core inflation spread between the two economies to its widest level since the data began in 1997. The extent of the slowdown in core inflation in the eurozone is noteworthy in its own right – it has occurred despite a sizeable increase in unit labour costs over the past year as firing failed to keep pace with the fall-off in output. But given that we would expect core inflation to trend down in response to a slowdown in growth, the strength of UK ex-food, exenergy inflation is more the anomaly to explain. Source: Reuters EcoWin Pro Breaking down core inflation First, slicing core inflation into its two big components – core services and core goods – helps to explain Eoin O’Callaghan & Alan Clarke 29 January 2010 Market Mover 15 www.GlobalMarkets.bnpparibas.com
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Page 23 and 24: Japan: Polarisation in Machine Tool
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Economic Calendar: 8 February - 5 M
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Next week's T-Bills Supply Date Cou
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Economic Forecasts GDP Year 2009 20
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Market Coverage Market Economics Pa
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