Carney In A Corner, Markets Turn To BoE

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Sterling Jumps 2% Off The Lows

Following the sharp downside extension seen in the GBP complex over the last two weeks, driven by Brexit volatility and easing expectations, we actually saw a sharp rebound across the board over the last 48 hours as hopes for political stability in UK were boosted by the confirmation of Theresa May as the new Prime Minister. Yesterday’s moves were furthered by positive headlines indicating strong post-Brexit retail demand, however, the overall trend remains down.

The question on investors’ minds right now is “do the current moves in GBP represent merely short-covering or the start of a break-out higher?”

Given the depth of the move since the results of the referendum were announced, with GBP falling over 13% against USD, we have since staged a small 2% recovery, trading back up to the initial post-Brexit low, which largely represents a lack of catalyst for further downside at this stage. With Article 50 and the formal process of the UK leaving the EU yet to be announced, the introduction of a new and “steady” PM and a lack of significant post-Brexit data, the next clear catalyst for directional moves will be the Bank of England’s rates meeting tomorrow.

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Early Response By BoE Governor

Mark Carney has cited his experience as Bank of Canada Governor in 2008 as helping inform his response to the current situation. During that time Carney was renowned for taking early action in an effort to prevent a deeper downturn and was certainly quick to take to the wires to address the situation.

In the initial aftermath of the Brexit results, we heard immediately from BoE’s Carney, who reassured markets that the central bank stood ready to cushion markets with extra liquidity. Subsequently, we then had the release of the BoE’s Financial Stability Report, which saw the announcement of a reduction in the counter-cyclical buffer rates applied to banks, which moves from 0.50% to 0%, with the intention of freeing up to £105bln for lending. The emphasis here was to show the British public that far from the situation in 2008/9, the banks do have money to lend. That release also saw Carney describe the depreciation in Sterling as a normal function of the economy whilst also noting that further capital outflows would likely lead to a continued, undesirable decline in Sterling.

Returning to the issue of BoE action we then heard Carney in a second televised address noting that due to expectations of continued elevated uncertainty, the bank would be conducting liquidity auctions for banks on a weekly instead of monthly basis whilst also stating that the economic outlook has deteriorated, and some monetary policy easing will likely be needed over the summer. “These final comments prompted a sharp sell-off in GBP as markets increased their pricing for a rate cut by August, at which time the bank said they “will also discuss further the range of instruments at our disposal.”

July Rate Cut Swings In The Balance

With such a clear nod to a summer rate cut, markets initially moved to price in a July rate of at least 25bos with the rate swap market indicating a 60% likelihood of a rate cut at this month’s meeting. However, Despite the heavy rhetoric by the BoE Governor, a Reuters poll of industry analysts ahead of the Bank of England’s July rates meeting tomorrow shows that the majority of forecasters are now expecting the BoE to remain on hold.

With only a few short weeks having elapsed since the Brexit result, there is the possibility that the BoE will instead choose to remain on hold until August, by which time they will have received more data and can better judge the appropriate level of response. The BoE Governor did state that he viewed the July and August meetings as a package which lends support to the idea that the BoE will proceed with a small 25bps cut at this meeting and further action at the August Meeting.

Carney’s immediate and decisive response could well prove to have negative consequences as the risks of Brexit are still in their first phase and the situation could be yet worse if, for example, the Article 50 negotiations hit a rough patch. What is clear at this stage is that with a small and potentially ineffective 25bps cut priced in, regardless of the BoE cutting rates tomorrow, the key importance falls on further guidance and the need for the BoE to give a clear indication as to both their readiness to act and the scope of the action they can take. Failure to convince markets at this meeting risks significantly damaging the BoE’s credibility, fuelling a sharp adverse reaction, in the same way, the ECB disappointed markets in Dec 2015 and suffered the consequences.

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