Will Sterling U-Turn On BoE?
Pound to Euro Looks Likely to Extend its Uptrend After the BOE Leaves Rates Unchanged
Sterling gained a substantial boost after the recent meeting of the Bank of England (BOE) on Thursday July 14. Investors had been expecting the BOE to cut interest rates from their
current 0.50% level to 0.25%, and possibly even increase quantitative
easing (QE) too. In the immediate aftermath of the Brexit vote on June 30 the governor
of the BOE had said he would almost certainly now be cutting rates or
using some other stimulus measures such as QE to ensure the economy was
buffered against the potential negative effects of Brexit. However, in the end, he and the rest of the MPC (well all bar one) were not moved to press the button on more stimulus. This was seen as an endorsement of the economy - and indeed the July
summary and minutes do emphasise how well the banking system had held
up after the shock. Most financial markets too have recovered. That is why sterling rose so rapidly in the minutes after the BOE meeting decision.GBP/EUR pushed
higher following the BOE’s endorsement that the status quo was adequate.
Could the pair now build on these gains and go even higher?
The fact the BOE stated they would still be probably cutting rates
and possibly increasing QE at their August meeting took the edge of the
rise, however, the currency has still kept hold of at least half its
gains.
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Short covering sparked strong rallies for most of Tuesday's major currencies. Both GBP/USD and USD/JPY soared more than 2% as some of the yen crosses enjoyed gains over 3%. There was no specific catalyst but the prospect of new stimulus from Japan and the U.K. continued to revitalize risk appetite and lead to further gains for high-beta currencies. Given the extent of short sterling and long yen positions post Brexit, the magnitude of this week’s reversals is not surprising. The gains for USD/JPY should be sustainable but for sterling, we are convinced that this is nothing more than a short squeeze. There were no major U.S. economic reports released Tuesday but in the last 24 hours we heard from 3 FOMC voters – Mester, Tarullo and Bullard. Tarullo didn’t make any comments on the economy but Mester and Bullard were optimistic with Mester saying he’s positive on the U.S. labor market and Bullard noting that ultimate Brexit impact on the U.S. is close to zero, which supports the sharp rise in U.S. rates and rally in USD/JPY. The yen, on the other hand, fell because the Japanese government is preparing a powerful punchbowl of fiscal and monetary stimulus whereas pound is rising because the U.K. has found a new Prime Minister, eliminating one of many post-Brexit uncertainties. While the nearly 500-pip reversal in GBP/USD may seem large, on a percentage base it amounts to only a 3.5% rally and the pair is still down 11% from its pre-Brexit high.
The Bank of England will be easing monetary policy, probably not Thursday but certainly before the end of summer. Considering that 63% of the economists surveyed by Bloomberg expect a rate cut, the rally in the British pound indicates that investors expect otherwise. However even if the BoE holds rates steady, Governor Mark Carney won’t miss the opportunity to prepare the market for a cut later this summer. He’s already said they are waiting for their August forecasts, which will undoubtedly harden their plans to ease. In his Testimony before the Treasury Tuesday, Carney defended his decision to warn about Brexit and stressed the need to remain vigilant about its risks. With Article 50 still not invoked, we have yet to see the long-term consequences of the U.K.’s decision. But in the near term, investment and consumption will slow, giving the central bank plenty of reasons to be cautious. There was broad-based weakness in the U.K. economy before Brexit with retail sales and average hourly earnings growth slowing alongside construction- and service-sector activity. Now that Britons have voted to leave the European Union, economic reports will worsen in the coming months and if Carney wants to get ahead of all this, he will need to confirm that easing is on its way.
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