Mark Carney, Governor of the Bank of England; Image via Bank of England / Flickr
Policy Efficacy Hampered By Market Expectations
There has been a disturbing dislocation in the relationship between rate moves and price action this year with a slew of central banks suffering hard-to-explain, adverse market reactions.
Following the BOJ’s historic move into negative rates this year, the JPY was, after an initial spike lower, heavily bid over the ensuing months and continued to attract demand despite BOJ intervention. Similarly, the RBA cut rates in May and despite some initial downside, AUDUSD is now trading above that level. Furthermore, despite an initial reaction lower following their most recent rate cut on August 2nd, again AUDUSD rallied to reverse losses over the following day. The RBNZ fell victim to the same fate too with NZDUSD now over 600 pips above the price of their March 10th rate cut.
This pattern of markets rallying in the face of rate cuts can be seen firstly as a function of the dwindling efficacy of conventional policy adjustments in the post-GFC environment and also as a representative of the growing power of market expectations around these meeting with central banks held hostage by insatiable speculation.
Studying this pattern poses a serious question ahead of the August BOE meeting: With markets so highly expectant of BOE easing and the BOE having given such as the clear declaration of their intention to ease, is GBP vulnerable to experiencing the same boomerang effect seen elsewhere?
GBP Shorts At Extreme Levels
Non-Commercial short positions have risen to their highest ever level in GBP as speculation continues to build ahead of the August BOE meeting. This extreme level of positioning clearly leaves GBP open to a short squeeze at the very least. The last time that GBP positioning (-81k) reached a similar level (-78k contracts in 2013) GBPUSD proceeded shortly after to rally by nearly 2000 pips and looking further back at the positioning data shows yet more examples of a similar reaction when positioning has approached this region.
So Much Is Already Priced In
The level of expectation in the market is a reflection of the strong guidance given by the BOE at their July meeting where they left little doubt as to the prospect of August easing. Markets are forecasting a 25bps alongside the implementation of additional measures.
If the BOE were to cut rates by more than 25bps, this might deliver some fresh GBP downside. However, the message communicated by the BOE over recent times has been one of sincere anxiety around the effectiveness of low rates given their clear ineffectiveness in other regions.
BOE’s Forbes has warned against the cost of easing monetary policy which she says will hit people’s savings, banks profitability and lending activities, as well as the ability of consumers and businesses to get credit. Carney too has warned against low rates and the hit to bank profitability and credit availability. With that in mind it seems unlikely that the BOE would opt to move into the Zero bound for rates which leaves the focus on either the utilisation of other measures alongside a rate cut such as an expansion of QE or the bank’s funding for lending scheme, or alternatively a simple 25bps cut accompanied by strong signalling further easing to come.
QE A Complicated Proposition
Whilst some analysts are indeed forecasting that the BOE will expand its QE program by another £50-£75bln we might not see that introduced immediately but perhaps put on ice until the November meeting. Unlike 2008, banks are much better capitalised, and there is no significant strain on financial sector solvency and liquidity arguing the urgent need for gilt purchases, and so maybe another channel such as the bank’s Funding For Lending scheme will appear more appropriate at this stage whilst the bank waits for further post-Brexit data to be assessed.
UK Data Pointing Down
However, what is clear from just the initial survey data received post-Brexit is that there has been a sharp contraction in the economic climate with July PMI data showing all three indicators (Services, Manufacturing & Construction) printing below the 50 level, indicating the fastest economic contraction since 2009. Services PMI especially, which is a leading UK indicator, fell to an 88month low. The picture painted by consumer sentiment is also bleak with GFK July Consumer Confidence printing -12, marking a 7 year low.
The BOE are in a difficult place and do not want to risk losing credibility in the face of the market which risks undermining the efficacy of both future measures and the power of future guidance. The BOE will be well aware of the implications of disappointing market expectations at a time when they are reliant on a weaker GBP to boost UK exports.
However, given the complicated manner in which currencies have been reacting to rate cuts and easing measures this year, it is difficult to gauge the likely reaction tomorrow. If the BOE do surprise with either a greater than 25bps cut and or QE expansion, there is likely to be some GBP weakening in the short term though given the extreme level of positioning in GBP its seems as though sooner rather than later GBP is in for a relief rally and a hesitant BOE might be just the catalyst.