Credit Suisse GBP Ahead of BoE
This Thursday’s long-awaited Bank of England meeting will be its first ‘Super Thursday’ since the EU referendum. The interest rate and QE decision, August minutes and Inflation Report’s forecasts will be released simultaneously at 12:45 LON – followed by a press conference at 13:30. Unfortunately, we believe it may be more of a ‘Duper Thursday’ than the ‘Super Thursday’ that many seem to be hoping for.
The MPC’s July minutes had already indicated “an immediate loosening of monetary policy, to be supplemented by a package of additional measures in August”. Since then we believe easing expectations have run rather high in the market, and short GBP positioning is a factor that could bias GBPUSD higher rather than lower. As such, we see better risk/reward playing for a disappointment rally GBPUSD than for a sharp move lower after the BOE. We believe this for the following reasons:
■ The bar for the BOE to ‘deliver’ seems high. This is most visible in the way UK assets outside of FX have rallied over the last fortnight.
■ The UK OIS market shows a 25bp August rate cut is now taken as a given.
■ Anticipation for asset purchases has pushed UK 10y yields yet another leg lower this fortnight, while UK corporate bond indices have rallied significantly over July. It is only in the last two days that UK fixed income markets have retraced some of these gains, as anxiety about a BOE disappointment has grown.
■ Among other factors, the rally in UK equity markets over the last fortnight might be linked to hopes for a dovish BOE and a weaker resulting exchange rate. This seems to be certainly one reason that could explain why UK-orientated equity indices like the FTSE250 have been so well supported, despite very weak UK economic data and a range-bound pound.
■ Even economists’ forecasts for this meeting seem bold. Around half now expect QE to be announced as soon as this meeting, compared to just 3 of 43 for the July meeting. Potential corporate bond buying and further Funding for Lending has already gathered traction.
■ The only major aspect of pricing in other asset markets that seems modest to expectations for further rate cuts. OIS imply a second cut to 0% is not priced even by late 2017. However we believe this may even reflect the fact that most market participants expect the BOE to utilize unconventional tools like QE when rates reach 0.25%.
Positioning suggests potent upside risks for GBPUSD. CFTC speculative positioning shows GBP shorts have extended further in July while longs have fallen. The resulting 57% net short position is by far the most stretched in G10 and in recent GBP history. Indeed we believe such short positioning is already one of the reasons why the pound has stayed so range bound over the last fortnight – despite multiple shocker data points that have undershot even our own economist’s bearish expectations. Positioning may also have prevented the pound weakening in the lead up to this meeting; which is typically the tendency of most currencies before major QE announcements (e.g., JPY in Jul 2016, EUR in Dec 2015, EUR in Jan 2015).
Risk reversals are near zero. Although overnight vol for the meeting date is at 30 vols, EURGBP and GBPUSD 1w risk reversal skews are ‘balanced’ near zero. We interpret this to mean that even if the market’s lofty expectations for BOE easing were to materialize, the resulting fall in GBPUSD is not expected to be especially more volatile even with such measures announced. By comparison, the 1-year risk reversal still seems well bid to the downside due to structural forces at play.
All in all, we believe these factors suggest a short and small pop higher in GBPUSD to 1.36 after the meeting seems plausible. Beyond the 1.36 level in GBPUSD, we expect selling pressures could intensify. After all, structural, political and economic factors still limit the extent to which sterling appreciation can be sustained. Yet what about the opposite scenario? In order for the pound to weaken we believe the BOE would need to surprise on several counts. On the whole, many of these areas seem problematic at this stage.
■ Corporate bond buying: Expressing a desire to buy a broad range of assets besides gilts and commercial paper would be dovish signal; especially at such an ‘early stage’ when first announcing a new QE programme. The BOE has previously purchased UK corporate bonds, but its eligibility criteria was limited to companies making a ‘material contribution to economic activity in the UK’. However the BOE’s last list of eligible corporate bonds for such rules amounted to just GBP57bn in 2014, and it is well known that the UK corporate bond market is relatively small even if were to relax such rules. At this stage the BOE may also be mindful of the liquidity and scarcity problems ECB/BOJ are currently facing by becoming the dominant buyer in small markets. Moreover, there is little evidence to suggest UK corporates are struggling to access very cheap capital at the moment (e.g., in the Eurozone).
■ Real estate ETF purchases: One new targeted measure we think would be feasible is to provide a ‘guarantee’ to support commercial real estate ETFs should they come under distress (like they did in July 2016). While we think this would initially be seen as a sensible innovation, it is however unlikely to generate a sustained weakening of the pound. Smaller measures (like amending the Funding for Lending scheme) should also not impact the currency heavily, in our view.
■ Being open to negative rates: During February’s G20 conference Carney’s seemed vocal about the unknown dangers of negative rates – and we believe he is aware of the negative impact such policies could have on the UK’s large financial sector. As such a larger than expected 50bp cut – or language that seriously suggests negative rates are on the cards – would be a dovish surprise.
■ Delivering a materially a bearish prognosis of the UK economy: We believe a sincere assessment of the economy (e.g. a recession forecast) could be politically awkward for the Bank of England at this meeting. It may not want to be seen as ‘scaring’ the wider public, firms and investors – as it was criticised for doing in the referendum campaign. We believe the risk is skewed towards the BOE being cautious on this occasion; also because it might not want to be seen as expressing views on how UK/EU politics could unfold over coming months.
■ Explicit comments about the benefits of a weaker pound: UK policymakers have not refrained from commenting about the desire to rebalance towards exports in the past. Not only have Government ministers mentioned this, but Carney’s predecessor Mervyn King notably said how a weaker pound would be “helpful” during the very heat of the 2009 crisis. However we believe the BOE could again find it awkward to make similar comments at this meeting. First, its inflation forecasts are being revised materially higher at the same time. Second, it may want to avoid the perception of adding panic back into the relatively ‘calm’ pound at the moment.