Global growth was lower than expected in 2018 Q4, the near-term outlook has softened and sentiment in financial markets around growth prospects has deteriorated. Corporate bond spreads widened markedly and equity prices fell at the end of 2018, before recovering somewhat in January. Market-based expectations for policy rates have fallen, such that overall global financial conditions are broadly unchanged. UK asset prices have responded to those global developments, and have remained sensitive to news related to Brexit. In particular, wholesale bank funding costs have risen. If persistent, this may put some upward pressure on interest rates facing households and companies.
1.1 Global economic developments
UK-weighted global GDP growth in 2018 Q4 is expected to have been lower than projected in the November Report at 0.4%, and lower than in the first half of 2018 (Table 1.A). That reflects softer data in a number of economies. Growth in the euro area has been weak, averaging 0.2% a quarter in 2018 H2, although some of that may reflect temporary factors. Growth in China weakened, while indicators point to lower growth in the United States in Q4. The slowdown through 2018 has partly reflected the past tightening in global financial conditions, as policy was tightened in the US and China. It has also been associated with slowing world trade growth: annual growth in world goods trade fell to 2.8% in the three months to November from around 5% at the start of the year (Chart 1.1). The recent decline has partly reflected the impact of higher tariffs on trade between the US and China.
In part reflecting weaker data, sentiment in financial markets around global growth prospects has deteriorated and that has affected asset prices. Equity prices in advanced economies fell sharply at the end of 2018 before recovering in the run-up to this Report (Chart 1.2). In contrast, equity prices in some emerging market economies, where growth appears to have stabilised after slowing earlier in 2018, have risen somewhat since November.
Non-financial corporate bond spreads have widened (Chart 1.3), also partly reflecting the deterioration in sentiment around global growth prospects. Market intelligence suggests that other factors may have played a role as well, including concerns about particular sectors and issuers and the end of ECB corporate bond purchases. Spreads are now closer to their historical averages, having been compressed for some time.
As sentiment about the global growth outlook has worsened, market expectations for the future path of policy rates have adjusted downwards (Chart 1.4), also reducing longer-term interest rates (Chart 1.5). Those falls in market interest rates broadly offset the moves in equity prices and corporate bond spreads such that global financial conditions are little changed since the November Report (Chart 1.6).
Oil prices have fallen sharply and are around 25% lower than they were in the run-up to the November Report (Chart 1.7). While the weaker global demand outlook is likely to have weighed on prices, supply factors, such as increased Russian and Libyan production, also appear to have been important. Consistent with that, the prices of some other commodities that tend to be sensitive to global demand, such as metals, have fallen by less.
While the fall in oil prices will give some support to global GDP growth, four-quarter growth is still expected to slow from 2.4% in 2018 Q3 to 1.9% in 2019 Q3, slightly below its estimated potential rate. That slowing is somewhat greater than was anticipated in November. Further out, growth is expected to stabilise, supported by the lower path for risk-free interest rates (Section 5).
Quarterly euro-area GDP growth averaged 0.2% in 2018 H2, lower than 0.4% in 2018 H1 and substantially lower than the average of 0.7% over 2017 (Table 1.A).
GDP growth in 2018 H2 was affected by temporary factors. In Q3, growth was affected by a fall in production in the auto sector. That had a particularly marked impact on German output, which contracted. New EU vehicle emissions standards were introduced at the start of September and resulted in significant bottlenecks in car production. It is possible that temporary factors have continued to affect growth in Q4 as recent protests in France have disrupted some service sector activity.
Underlying growth in the euro area also appears to have slowed in 2018, however. Net trade dragged on quarterly growth through much of 2018, compared to a marked boost in the previous year. Export growth to China and other emerging market economies (EMEs) fell markedly in 2018 H1 as demand growth in those countries slowed. Increased trade tensions, which have weighed on world trade more generally (Chart 1.1), may have affected euro-area exports since.
Despite the slowdown in growth, the euro-area unemployment rate was 7.9% in December (Chart 1.8), its lowest rate since 2008 Q4. At the same time, euro-area wage growth has continued to pick up. As rising wage growth leads to a gradual building of inflationary pressures, core inflation is expected to rise gradually in coming quarters. Since November, the European Central Bank (ECB) has made no changes to policy rates and has ended net purchases under the asset purchase programme.
Euro-area growth is projected to remain sluggish in the near term (Table 1.B), as some of the factors that have weighed on growth persist. The euro-area PMIs were weak in January, falling to their lowest levels in over five years. Some risks to the outlook have moderated somewhat. Political risks in Italy have lessened following the Italian government’s 2019 budget plan being agreed with the European Commission at the end of December. Consistent with that, long-term interest rates on Italian government debt have fallen back (Chart 1.5).
The United States
GDP growth in the US had been strong through much of 2018, driven by solid domestic demand. That was supported by strong employment growth and fiscal policy. Tax cuts announced in December 2017 boosted business and consumer spending. Continued growth is judged to have absorbed spare capacity fully in the US economy. The headline unemployment rate was 4.0% in January while wage growth remained firm. The Federal Open Market Committee (FOMC) continued to tighten monetary policy during 2018 with the target range for the federal funds rate reaching 2¼%–2½% in December.
GDP growth is expected to have slowed in 2018 Q4, to 0.5%, 0.3 percentage points lower than expected in November and down from 0.8% in Q3. Part of that slowing is likely to reflect some fading of the boost to investment from corporate tax cuts. Growth in spending on new equipment has slowed since the start of the year, for example.
Reflecting weaker data and market participants’ expectations of the FOMC’s reaction to that, the path of policy implied by market prices has fallen markedly since November (Chart 1.4). The median projection of FOMC members for the federal funds rate at end-2019 has also fallen from 3.1% to 2.9%.
US activity is expected to slow further in the near term as the boost to growth from fiscal policy continues to wane. In addition, the recent partial US government shutdown is expected to have a small negative impact on growth in Q1, although that should boost growth by a similar amount in Q2. Four-quarter growth is expected to fall from 2.9% in 2018 Q4 to 2.0% in 2019 Q3.
GDP growth in China slowed throughout 2018 (Table 1.A). Four-quarter GDP growth fell to 6.4% in 2018 Q4 from 6.8% in Q1. Much of that slowdown reflects policies enacted to reduce risks in the financial system, which have weighed on credit growth and investment.
Trade tensions with the US may have also weighed on growth. The impact of these has been apparent in financial markets: the Shanghai Composite equity index has fallen by 25% since January 2018 (Chart 1.2). There is also some evidence of the effect of higher US and Chinese tariffs in recent trade data. The value of Chinese exports to the US fell by 3.5% in the year to December 2018.
GDP growth is expected to slow a little further in 2019. While tariffs are expected to weigh on growth, stimulus provided by the Chinese authorities — for example the announced cuts to the banks’ reserve requirement ratio in January 2019 and tax cuts — should help support growth.
Other emerging market economies
Excluding China, EME growth was 0.8% in 2018 Q3 on a PPP-weighted basis, broadly as expected in the November Report but slower than growth rates over 2017. Higher-frequency indicators such as manufacturing PMIs are consistent with a further slowdown in activity in Q4.
Tighter financial conditions, in part associated with the tightening of US monetary policy, contributed to weaker activity in EMEs over 2018. Since November, emerging market currencies have appreciated somewhat (Chart 1.9) and equity indices have outperformed those in advanced economies (Chart 1.2). Financial conditions in Argentina and Turkey — the two countries which had been particularly adversely affected — have also stabilised.
Quarterly GDP growth in non-China EMEs is expected to pick up a little in 2019, broadly in line with expectations at the time of the November Report.
Global GDP growth slowed in 2018 H2
GDP in selected countries and regionsa
- Sources: Eikon from Refinitiv, IMF World Economic Outlook (WEO), National Bureau of Statistics of China, OECD, ONS and Bank calculations.
a Real GDP measures. Figures in parentheses are shares in UK exports in 2017.
b The 1998–2007 average for China is based on OECD estimates. Estimates for 2008 onwards are from the National Bureau of Statistics of China.
c The earliest observation for Russia is 2003 Q2.
d Constructed using data for real GDP growth rates for 180 countries weighted according to their shares in UK exports. Figure for 2018 Q4 is a Bank staff projection.
Growth in world trade slowed in November
World trade in goodsa
- Sources: CPB Netherlands Bureau for Economic Policy Analysis and Bank calculations.
a Three-month moving average. Volume measure. Data not available for US import/export values in November.
Equity prices have fallen a little in advanced economies
International equity pricesa
- Sources: Eikon from Refinitiv, MSCI and Bank calculations.
a In local currency terms, except for MSCI Emerging Markets which is in US dollar terms.
b The MSCI Inc. disclaimer of liability, which applies to the data provided, is available here.
Corporate bond spreads have widened
International non-financial corporate bond spreadsa
- Sources: Eikon from Refinitiv, ICE/BoAML Global Research and Bank calculations.
a Option-adjusted spreads on government bond yields. Investment-grade corporate bond yields are calculated using an index of bonds with a rating of BBB3 or above. High-yield corporate bond yields are calculated using aggregate indices of bonds rated lower than BBB3. Due to monthly index rebalancing, movements in yields at the end of each month might reflect changes in the population of securities within the indices.
Market-implied paths for interest rates have fallen since November
International forward interest ratesa
- Sources: Bank of England, Bloomberg Finance L.P., ECB and Federal Reserve.
a The February 2019 and November 2018 curves are estimated using instantaneous forward overnight index swap rates in the 15 working days to 30 January 2019 and 24 October 2018 respectively.
b Upper bound of the target range.
Monitoring the MPC’s key judgements
Long-term interest rates have fallen in advanced economies since November
Ten-year nominal interest ratesa
- Sources: Bloomberg Finance L.P. and Bank calculations.
a Zero-coupon spot rates derived from government bond prices.
Global financial conditions are broadly unchanged since the November Report
Global financial conditions indexa
- Sources: Bloomberg Finance L.P., Eikon by Refinitiv and Bank calculations.
a Financial conditions indices (FCIs) estimated for 43 economies using principal component analysis. The FCIs summarise information from the following financial series: term spreads, interbank spreads, corporate spreads, sovereign spreads, long-term interest rates, equity price returns, equity return volatility and relative financial market capitalisation. An increase in the index indicates a tightening in conditions. Data are to end-January 2019. Series shows the average of all country FCIs, weighted according to their shares in world GDP using the IMF’s purchasing power parity (PPP) weights. Calculated as the weighted average of the following country FCIs: Argentina, Australia, Austria, Belgium, Brazil, Bulgaria, Canada, Chile, China, Colombia, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, India, Indonesia, Ireland, Israel, Italy, Japan, Malaysia, Mexico, Netherlands, New Zealand, Norway, Peru, Philippines, Poland, Portugal, Russia, South Africa, South Korea, Spain, Sweden, Switzerland, Thailand, Turkey, UK, US and Vietnam.
Oil prices have fallen sharply since November
US dollar oil and other commodity prices
- Sources: Bloomberg Finance L.P., Eikon from Refinitiv, S&P indices and Bank calculations.
a Calculated using S&P GSCI US dollar commodity price indices.
b Total agricultural and livestock S&P commodity index.
(c) US dollar Brent forward prices for delivery in 10–25 days’ time.
The euro-area unemployment rate has fallen while wage growth has picked up
Euro-area unemployment rate and wages
- Sources: Eikon from Refinitiv and Eurostat.
a Percentage of economically active population. Data are monthly and to December 2018.
b Compensation per employee. Data are quarterly and to 2018 Q3.
Sterling has been volatile
Effective exchange rates
- Sources: Bank of England, ECB, Federal Reserve, JPMorgan and Bank calculations.
a JPMorgan Emerging Markets Currency Index.
b Federal Reserve US dollar nominal broad index.
1.2 Developments in UK financial conditions
Concerns around the global outlook have affected UK asset prices alongside those in other advanced economies. In addition, UK asset prices have been sensitive to developments related to Brexit.
In the run-up to this Report the sterling ERI was 1% lower than in November and was around 17% below its November 2015 peak. Sterling has been volatile over the past three months. It fell at the end of 2018 before recovering in recent weeks (Chart 1.9).
Implied volatilities from sterling options — which are measures of the uncertainty around the outlook for the exchange rate — also rose at the end of 2018 before falling back in early 2019 (Chart 1.10). They remain higher than in recent years and much higher than for other currencies.
Market participants still place more weight on sterling depreciating than appreciating in coming months. Although the cost of insuring against a large depreciation relative to a large appreciation — known as the risk reversal — has fallen since November, it still suggests that it is more expensive to insure against a large depreciation (Chart 1.10).
Market interest rates
Short-term risk-free interest rates have fallen in the past three months. In the run-up to this Report the market-implied path of Bank Rate over the next three years was around 20 basis points lower, on average, than in November (Chart 1.4). It is now expected to reach around 1.1% in three years’ time. Market intelligence suggests that the fall in rates reflects a weaker global outlook alongside concerns about Brexit, with participants anticipating a lower trajectory for rates under a disorderly scenario. As explained in Box 4 of the November 2018 Inflation Report, the MPC judges that the monetary policy response to Brexit, whatever form it takes, could be in either direction.
Longer-term UK interest rates have also fallen since the November Report, as in other advanced economies. While some of the fall at the end of 2018 was reversed in January, the yield on 10-year UK government bonds was still around 30 basis points lower than in November (Chart 1.5). Market contacts have attributed that fall to an increased preference among investors for less risky assets and a lower expected path for policy rates in the US.
Corporate capital markets
Spreads on non-financial corporate bonds across the main markets in which UK companies borrow widened markedly at the end of 2018 (Chart 1.3) and corporate bond issuance was weak. Spreads have fallen back somewhat in January and issuance has resumed at more normal levels. Falls in risk-free interest rates mean that overall financing costs for companies have only risen a little since November.
In the run-up to the February Report, UK equity prices were around 3% lower than in November (Chart 1.2). As in other advanced economies, UK equity prices fell at the end of 2018, before recovering in January.
Bank funding costs and retail interest rates
The cost of bank funding in capital markets is important for broader credit conditions as it influences the interest rates banks charge on loans to households and companies. Similar to spreads on non-financial corporate bonds, UK banks’ unsecured funding spreads have increased since November (Chart 1.11).
The impact of these higher funding costs on credit conditions will depend in part on whether the rise persists. To the extent that Brexit uncertainty has pushed up spreads, they could fall back as clarity over the outcome increases. UK banks have not issued much debt in recent months at these higher funding spreads, in part due to strong issuance earlier in 2018. But as they will need to resume issuance in coming months, a persistent rise in spreads would increase their funding costs and put some upward pressure on the interest rates facing households and companies.
Any persistent rise in unsecured wholesale funding costs is expected to have less impact on the interest rates facing households and companies than in the past, however. As discussed in Box 1, while banks have historically used wholesale unsecured debt as a benchmark measure for their marginal source of funding, the structure of banks’ balance sheets has changed significantly since the crisis and the use of alternative sources of funding has increased. Spreads on other sources of funding, such as covered bonds, have risen by less than spreads on unsecured debt (Chart 1.11).
Other factors will also affect the interest rates facing households and companies. Retail interest rates have been stable in recent months and remain at low levels (Section 2). Recent discussions with lenders have highlighted the impact of continued competition in the mortgage market on retail rates. If competition intensifies, that would put downward pressure on mortgage rates. Further, as noted in the November 2018 Inflation Report, banks are expected to increase deposit rates by somewhat less than any pickup in risk-free rates over coming quarters. That would provide scope to limit increases in retail lending rates without affecting banks’ profitability.
Market participants still place more weight on sterling depreciating than appreciating
Six-month sterling-US dollar risk reversal and implied volatility
- Sources: Bloomberg Finance L.P. and Bank calculations.
a 25-delta risk reversals. Risk reversals show the difference between the implied volatilities of equally ‘out-of-the-money’ put and call options. Negative risk reversals mean that it is more expensive to insure against currency depreciations than appreciations.
UK wholesale bank funding spreads have widened in recent months
UK banks’ indicative funding spreads
- Sources: Bank of England, Bloomberg Finance L.P., IHS Markit and Bank calculations.
a Unweighted average of spreads for two-year and three-year sterling quoted fixed-rate retail bonds over equivalent-maturity swaps. Bond rates are end-month rates and swap rates are monthly averages of daily rates.
b Constant-maturity unweighted average of secondary market spreads to mid-swaps for the
major UK lenders’ five-year euro-denominated bonds or a suitable proxy when unavailable.
For more detail on unsecured bonds issued by operating and holding companies, see the 2017 Q3 Credit Conditions Review.
Box 1 Bank funding costs and loan pricing
When pricing a new loan, banks aim to reflect the costs and risks of making that loan. While banks will take other costs and risks into account, the marginal cost of funding is a key driver of lending rates.1
Banks use several sources of funding. They take deposits from households and companies, as well as borrowing in wholesale funding markets. Historically, banks have tended to use wholesale unsecured funding as their main measure of the marginal cost of funding. This is a useful indicator because it is a market in which it is possible to raise a large amount of funding relatively quickly and its cost is readily observable in terms of market pricing.
Supervisory intelligence, however, indicates that UK banks are placing less emphasis on wholesale unsecured funding as their main measure of marginal funding costs for most UK lending. Across the lenders that account for the majority of lending to UK households and small businesses, most are using a measure of marginal funding costs that takes into account other sources of funding, such as covered bonds and retail deposits. Some banks are also taking into account targets for their net interest margins and lending volumes when pricing loans. Consistent with this move away from unsecured funding, spreads on unsecured wholesale bank funding and spreads on mortgage lending have tracked each other less closely in recent months.
One reason for this is likely to be the substantial change in the structure of banks’ balance sheets since the financial crisis. Reliance on wholesale funding has fallen: the proportion of banks’ balance sheets accounted for by wholesale funding declined from over 40% in 2008 to less than 25% in 2017 . The counterpart of that has been an increase in the share of deposit funding, such that the value of banks’ deposits now slightly exceeds that of their loans (Chart B).
Given these developments, loan pricing is likely to be less sensitive to changes in wholesale unsecured funding costs. Since November, unsecured spreads have risen substantially while spreads on covered bonds and retail deposits have increased by much less (Section 1). While higher wholesale unsecured funding spreads are expected to persist for a time, reflecting continuing Brexit uncertainties (Section 5), the MPC judges that the impact of that on the interest rates facing households and businesses is likely to be less pronounced than it would have been in the past.
1 For more information see Cadamagnani, F, Harimohan, R and Tangri, K (2015), ‘A bank within a bank: how a commercial bank’s treasury function affects the interest rates set for loans and deposits’, Bank of England Quarterly Bulletin, 2015 Q2.
UK banks’ reliance on wholesale funding has fallen
UK banks’ wholesale fundingab
- Sources: Published accounts and Bank calculations.
a Wholesale funding comprises deposits by banks, debt securities and subordinated liabilities but excludes repo. Where underlying data are not published the previous figures have been used.
b Major UK banks peer group. Sample includes National Australia Bank between 2005 and 2015 H1.
(c) Residual contractual maturity of greater than three months.
d Residual contractual maturity of less than three months.
e Excludes derivatives and liabilities to customers under investment and insurance contracts.
The value of banks’ deposits slightly exceeds the value of their loans
Customer funding gapa
- a Calculated as the difference between bank lending to households and private non-financial corporations and deposits received from them.
Box 2 Monetary policy since the November Report
At its meeting ending on 19 December 2018, the MPC noted that the near-term outlook for global growth had softened and downside risks to growth had increased since the November Inflation Report. Global financial conditions had tightened noticeably, particularly in corporate credit markets. Oil prices had fallen significantly, however, which was expected to provide some support to demand in advanced economies. The decline in oil prices also meant that UK CPI inflation was expected to fall below 2% in coming months. The Committee judged that the loosening of fiscal policy in Budget 2018, announced after the November Report projections were finalised, would boost UK GDP by the end of the MPC’s forecast period by around 0.3%, all else equal.
Brexit uncertainties had intensified considerably since the Committee’s November meeting. Those uncertainties were weighing on UK financial markets. UK bank funding costs and non-financial high-yield corporate bond spreads had risen sharply and by more than in other advanced economies. UK-focused equity prices had fallen materially. Sterling had depreciated further, and its volatility had risen substantially. Market-based indicators of inflation expectations in the United Kingdom had risen, including at longer horizons.
The further intensification of Brexit uncertainties, coupled with the slowing global economy, had also weighed on the near-term outlook for UK growth. Business investment had fallen for each of the past three quarters and was likely to remain weak in the near term. The housing market had remained subdued. Indicators of household consumption had generally been more resilient, although retail spending could be slowing.
The MPC had previously noted that shifting expectations about Brexit among financial markets, businesses and households could lead to greater-than-usual short-term volatility in UK data. Judging the appropriate stance of monetary policy requires separating these shorter-term developments from other more persistent factors affecting inflation and from the dynamics of the economy once greater clarity emerges about the nature of EU withdrawal.
Domestic inflationary pressures had continued to build. The labour market remained tight, with employment growth having picked up in the latest data and the unemployment rate projected to stay around 4% in the near term. Annual growth in regular pay had risen to 3¼%, stronger than anticipated in the November Report. In contrast, services CPI inflation had been subdued. The inflation expectations of households and professional forecasters were broadly unchanged.
The Committee judged in November that, were the economy to develop broadly in line with its Inflation Report projections, which were conditioned on a smooth adjustment to the average of a range of possible outcomes for the UK’s eventual trading relationship with the European Union, a margin of excess demand was expected to emerge. In that context, an ongoing tightening of monetary policy over the forecast period, at a gradual pace and to a limited extent, would be appropriate to return inflation sustainably to the 2% target at a conventional horizon.
The MPC noted that the broader economic outlook would continue to depend significantly on the nature of EU withdrawal, in particular: the form of new trading arrangements between the European Union and the United Kingdom; whether the transition to them is abrupt or smooth; and how households, businesses and financial markets respond. The appropriate path of monetary policy would depend on the balance of the effects on demand, supply and the exchange rate. The monetary policy response to Brexit, whatever form it takes, will not be automatic and could be in either direction. At the time of its December meeting, the MPC judged that the current stance of monetary policy remained appropriate.