From an economic perspective, the UK certainly has ‘skin in the game’ when it comes to Eurozone QE and its effectiveness. In terms of the impact of Eurozone sovereign QE on the UK, it makes sense to distinguish between the economic impact from financial market moves, and those from the actual performance of the Eurozone economy.
Overall, we are hopeful that the spill-over from ECB QE on the UK would be positive, with the impact of lower gilt yields and stronger Eurozone nominal demand in time dominating any negative activity impact from upward pressure on sterling. Still, the impact and success of ECB QE is highly uncertain, and in the short-run it is certainly not impossible that the dampening effect on UK exports from any appreciation of GBPEUR could dominate for a number of quarters.
UK rates markets have, over the past five months or so, decoupled from their earlier relationship to the (recovering) US, and recoupled with their (ailing) Eurozone equivalents. As expectations over sovereign bond QE intensifies, Gilts are, in our view, likely to outperform Bunds, and 10y GBP swaps could well perform in line with EUR swaps. We reiterate our recommendation to receive 10y GBP swaps vs. 10y EUR and 10y USD.
We continue to see sterling generally outperforming its peers in G10 over the first half of 2015. While we expect data outperformance, leading to some degree of adjustment in rate expectations, to be the primary driver, the announcement effect of ECB QE could accelerate EURGBP downside towards our longer-term targets in the cross, which lie below 0.75.
However, as is the case with the corresponding ECB/Fed balance sheet vs EURUSD relationship, balance sheet differentials in general fail to have a lasting impact on exchange rates, unless the scale of change is largely enough to generate a portfolio reallocation effect. The BoE’s assessment of exchange rate pass-through could also affect the BoE’s tolerance on sterling.
If, as we expect, the ECB were to launch full-blown QE in Q1 2015, we think it likely that UK equities would underperform their European peers. Over 75% of FTSE 100 revenues come from overseas and upward pressure on sterling would likely be a drag on earnings. We would prefer the domestic mid/small caps to the FTSE 100. However, further downward pressure on fixed income yields (even if temporary) would bring the cross-asset attraction of equities into sharper focus: the FTSE 100 yields 4.1% (2015E) and a 10yr Gilt Yield 1.8%.