Eugene Leow, Rates Strategist
DBS Group Research
An escalation in Brexit uncertainties has threatened to bring the British pound deeper below 1.30. On October 18, EU27 leaders agreed not to push for a special summit to sign off on Brexit. An estimated 700,000 people took to the streets in London on October 20 to demand a second referendum on Brexit. Queen Elizabeth broke, for the first time, her silence over Brexit during a state banquet for the King of Netherlands. Prime Minister Theresa May is reportedly attending 1922 Committee meeting today to face down another leadership challenge. To trigger a vote of no confidence against her, 15% or 48 Conservative members of parliament would need to submit letters to the 1922 Committee chairman. All events have pointed to UK lawmakers not knowing what they want out of Brexit.
According to a Reuters poll conducted in early September, when the British pound was around current levels just below 1.30, respondents reckoned that a No Deal Brexit would send the pound lower by 8% (or GBP/USD to as low as 1.19) while Any Deal Brexit would lift it by 6% (or 1.37). The Bank of England (BOE) agreed that a No Deal Brexit would hurt sterling and lead to another one-off shock to prices. On the economy, the central bank expects a real income squeeze on households for the next few years amidst higher trade tariffs. With less than 20% of UK firms having in place a plan for No Deal Brexit, there is also potential damage to supply capacity. Consensus has correspondingly downgraded UK’s economic outlook, especially in gross fixed capital formation and the exports/imports sectors. Neither does it help that the euro is being dragged down by the head on collision between Rome and Brussels over Italy’s big budget spending plans. Our forecast remains for GBP/USD to end 2018 lower at 1.25.
Rates: Credit is tight in China despite easing
Despite numerous steps by the People’s Bank of China (PBoC) to ease monetary policy, funding conditions for the private sector is still tight. To be sure, by many measures, interest rates have fallen. Short-term interest rates have been guided lower with the 7D repo hovering in the 2.4-2.8% range, compared to 3.0-3.5% in early part of the year. The fall in 3M Shibor is even larger, down by about 200bps since end-2017. Longer-term govvies have also rallied driving 10Y yields to 3.60%, about 30bps lower over the same period. That said, the passthrough to corporate borrowing costs is limited.
We have defined corporate credit spreads as 3M CP (AA-) less 3M Shibor and 5Y credit (AA-) less 5Y govvie to capture the short-term and long-term financing conditions respectively. By these measures, lower Shibors and govvie yields have not translated into lower borrowing costs for corporates…yet. As long as credit spreads stay wide, we can reasonably expect the PBoC to maintain loose monetary policy, especially against a much more challenging global growth backdrop. It probably does not help that shadow banking (defined as entrusted loans, trust loans and bank acceptances) has become a drag on the economy. As a result, the flow of credit to the private sector has become constrained. In response to weak monetary policy transmission thus far, the government recently announced pro-active fiscal policy (personal income tax cuts, local government bond issuances and the provision of credit support for debt sales). These measures should have a much quicker positive impact on the economy but will come at the expense of the government’s balance sheet.