Shift in Tone by BOE
Comments by BOE Governor Mark Carney at last week’s Sintra panel saw strong Sterling demand kick in as markets reacted to the BOE’s perceived shift in sentiment. The BOE governor declared that the debate about raising rates before year end is now “live” among the MPC. The key takeaway from this event was the insight it gives into the bank’s reaction function. The BOE continues to become more intolerant towards sterling weakness which should keep GBP supported.
Why does the BOE Want a Stronger Pound?
With most central banks looking for a weaker currency it seems there are only two real reasons why the BOE is looking for a stronger Pound.
- The advantages of a weaker currency have been less than the bank expected. While PMI data sets show that manufacturing confidence is back to post-crisis highs, it seems that this is largely tied to robust European growth and, as yet, there aren’t any signs of a significant shift in resources into the industrial sector. The manufacturing sector has lost 30k jobs since the referendum last year, as part of an overall gain of 300k jobs, making it the worst performing sector. Alongside this, trade balance data excluding Oil and erratics shows that there is a remaining deficit.
- Not only have the advantages of a weaker currency been less than expected, but the costs of the currency decline have also been higher than expected. Average weekly earnings have started to reverse while inflation has accelerated faster than expected due to the Sterling depreciation, weighing heavily on disposable incomes and household consumption.
Desire For Stronger Pound Made Clear
Policymakers have started to become more explicit about their unease over the exchange rate. Deputy governor Broadbent noted in March that the BOE saw the negative effects of a weak GBP via consumption outstripping the positive effects for exports and investment. BOE governor Haldane recently commented that the cost of living was a clear reason to tighten policy. Indeed, during Carney’s comments at the Sintra panel, he noted that need to sync the BOE’s policy with that of other global central banks though did note the idiosyncratic risk.
The Risks of Waiting
It is becoming clear to markets that the BOE view last year’s cut as an error and have subsequently suffered the effects of a weaker-than-expected currency. If this is the case, then the risks of waiting too long to tighten, against a backdrop of global central banks moving back towards a tightening phase, could be significant.
Despite some narrowing recently, the UK’s current account deficit still sits just shy of 4%. In order to fund the deficit, the UK has taken advantage of the ultra-dovish policies of other central banks since the crisis. The UK’s portion of the outflows from ECB QE is the biggest of any economy. However, if the ECB commences tapering in an earlier or more aggressive way, alongside Fed tightening, this would make it harder for the UK to gain foreign funding without greater GBP weakness. This would clearly further weaken real incomes in the UK and damage the BOE’s inflation target.
The BOE’s stated reluctance to tolerating any further GBP weakness presents a clear obstacle to any bearish forecast though, referring to the Carney’s speech, the bank will not be at the forefront of any global shift towards tightening. This is partly due to uncertainty surrounding Brexit negotiations but also because of the state of the UK consumer who suffers under a proper hiking cycle.
GBPUSD has now broken out of the short-term bull flag formation which sits within the medium-term bullish channel. However, on the back of a set of missed seen both the Manufacturing and Services PMI readings for June, the price is now retracing quickly.
Any retest of the broken flag formation is likely to find support as price continues to near the 2017 highs. Above there, a key focus will be on a test of the 1.3440s mid-2016 highs. A break back inside the flag formation will bring the rising trend line support from last year’s lows into focus.