Week ahead: China, a big call for the Bank of England, and the fallout from the BOJ

The big news last week was the change in yield curve control from the Bank of Japan, which effectively allows the 10-year government bond yield to rise to 1% from 0.5%. This is yet another central bank taking steps to tighten monetary policy, however, it is also highlighting a major de-synchronisation in the world of monetary policy: as the Fed, the ECB and, possibly, the BOE, are all close to the peak of their monetary policy cycle, the BOJ looks like it just embarking on a tighter form of monetary policy. In contrast, on the other end of the scale, Chinese authorities are under pressure to add more stimulus after more disappointing economic data for July and deflation continues to threaten the economy. 

The global manufacturing recession – What does it mean? 

The end of July does not seem like the ideal time to come up with big themes for financial markets, however, global monetary policy de-synchronisation is one worth watching. Another theme is the collapse in global manufacturing after extremely disappointing PMI reports for July. In Germany, manufacturing PMI dipped to its lowest level since the peak of the pandemic in 2020, at 38.8, which is deep in contraction territory. This dragged lower the overall Eurozone manufacturing PMI, which fell to 42.7, while in the UK the manufacturing PMI fell to 45. On Monday, we heard that the Chinese manufacturing PMI was 49.3, up a touch compared to June, but still in contractionary territory. The global manufacturing sector is deep in recession, however, what is worth noting is that this decline is not pervasive across all sectors of the global economy. For example, while the service sector remains strong, global manufacturing is experiencing a pronounced slowdown across developed markets. One reason for this is the shift in spending habits in the aftermath of the pandemic, away from goods and towards services. Secondly, high hopes for global manufacturing after the reopening of China’s economy earlier this year have been dashed as China’s economic growth has stalled. Added to this, higher monetary policy, especially in the West, has impacted sales growth for items such as cars and household white goods, which are frequently bought on credit. Economists are expecting the manufacturing sector to continue to lag service sector growth, as the global goods inventory cycle turns, and a global de-stocking takes place. The CEBR, an economic think tank, believes that it will take until Q1 2024 for this de-stocking to work its way through the UK manufacturing sector, which could lead to a drag on growth for the rest of this year. 

Fed achieves soft economic landing 

After the US economy posted a surprise 2.4% YoY growth rate for Q2, it seems likely that the US economy will manage a soft landing as the Federal Reserve succeeds at bringing down inflation. The Fed has managed this, even though interest rates are at a 40-year high, because proxy interest rates – the actual financing costs faced by households- have been falling in the US, for most of this year, as the market looks forward to the end of the Fed’s tightening cycle. Added to this, strong gains for US stock markets have also helped to boost the economy, and the consumer. This is a self-perpetuating cycle: consumers are not too fearful about rising prices and thus, higher interest rates, which in turn has boosted asset price valuations. This is most pronounced in the US, but it is also notable in Europe, which bounced back to growth in Q2, and in the UK, where expectations for a deep recession have so far proven to be wide of the mark. However, the decline in the manufacturing sector, particularly in the UK, Germany, and China, is worth watching. For now, the service sector can manage to prop up overall growth, but if there are signs that the service sector is faltering, then a recession could be on the cards. At this stage, Germany looks particularly vulnerable, while the US looks more protected after its durable goods orders for June rose by a healthy 0.6% even after transport orders were stripped out. 

The BOJ: Taking away and giving back at the same time 

The fallout from the BOJ meeting has been interesting. After Friday’s announcement, 10-year Japanese government bond yields surged to their highest level in 9 years, which is something that the BOJ was obviously not happy with. To counteract some of this volatility in its bond market, the BOJ on Monday announced an unscheduled 300bn Yen of bond buying to try and temper the surge in 10-year bond yields. This has not worked, and instead 10-year Japanese bond yields are up by 5 basis points on Monday. The market is likely to test the BOJ’s resolve when it comes to the tweak to its YCC policy, which could lead to more upside pressure on Japanese bond yields, even if the BOJ intervenes in the market. This highlights Japan’s complex monetary policy regime, which is weighing on the JPY, USD/JPY is up more than 0.7% at the time of writing and is close to its highest level since the second week in July. 

BOE preview 

Elsewhere, the Bank of England meeting on Thursday is attracting a lot of attention, after inflation in the UK, finally, started to retreat in June. The market is expecting a 25bp rate hike on Thursday to 5.25%. We agree with consensus on this one, and believe that the BOE will hike by 25bps, as inflation is expected to fall further in July and for the rest of this year, while there are signs that growth is retreating. The interesting part of the meeting will, of course, be the press conference. There are a few things to look out for at this meeting: 1, the vote split now that arch dove Tenreyro has left the MPC and been replaced by Megan Greene. 2, expectations for further rate hikes are likely to remain reasonable compared with recent months. The market is expecting rates to peak at 5.78% in February 2024, we do not expect the BOE to push back on this, although the BOE is likely to argue that future changes to Bank Rate will depend on the path of inflation and wage growth. The last thing to watch is quantitative tightening – will the BOE speed up the disposal of assets on its balance sheet? Currently it is £80bn a year, that could rise to £90bn or £100bn, however, we think that could be a story for September rather than the August meeting. 

GBP in the aftermath of the BOE decision 

The immediate market reaction to the BOE meeting is likely to be focused on the FX market. If the BOE hikes rates by 25bps as expected, then we may see little movement in GBP/USD as it has already retreated from the $1.31 highs reached in mid-July. However, a surprise 50 bp move from the BOE could send sterling surging across the board, with GBP/USD easily clearing the $1.30 hurdle and making its way back towards $1.32. This would also drag UK government bond yields higher.