While the Bank of England is widely expected to keep policy unchanged on Thursday, we look for two signals that could mark a positive turning point in GBP sentiment and end the 'Great British Sell-off' in currency markets
Our analysis in the final section of the note estimates GBP's reaction more broadly under 3 BoE 'on hold' scenarios (dovish hold, status quo hold, hawkish hold)
We believe that BoE officials may use the policy statement, accompanying minutes and vote split this week to try and shake up market expectations for the path of policy. Based on the UK OIS curve, implied market pricing suggests that there is a barely 1 in 4 chance of a 25bp Bank rate increase this year, which rises to only a 65% probability by the end of 2018. Likewise, surveys of households and businesses suggest that few anticipate meaningful increases in interest rates anytime soon.
While policymakers may be less concerned about the repricing of immediate rate hike expectations, what may be making some on the MPC nervous is the flattening bias over the 2-3 year part of the curve (see RHS panel of chart below). This is indeed starting to look at odds with an economy where inflation is set to rise close to 3% and economic growth remains positive, if somewhat subdued.
The minutes of the August MPC meeting stated that if the economy followed a path similar to the one the BoE anticipated “then monetary policy could need to be tightened by a somewhat greater extent… than the path implied by the yield curve”. This sentiment has been repeated in several subsequent BoE speeches and is likely to remain within the accompanying text.
However, while this message may provide a backstop to any further flattening of the UK rate curve, we suspect that any meaningful uplift in short-term rates is unlikely to be achieved unless there is a hawkish shift in the vote split.
Any meaningful uplift in short-term rates is unlikely unless we get a third MPC member calling for an immediate rate hike
External members Ian McCafferty and Michael Saunders will likely again vote in favour of an immediate 25bp rate rise, but the key story will be whether BoE Chief Economist Andy Haldane finally follows through with his threat to vote for a hike. Back in June, he warned that “the balance point [between tightening ‘too early’ and ‘too late’]… has shifted. Certainly, I think such a tightening is likely to be needed well ahead of current market expectations.”
With this week’s data flow set to show headline inflation jumping back to 2.8%, wage growth edging higher and employment growth remaining robust, there is the clear potential for a 6-3 MPC vote split – with a third dissenter joining the ranks.
Such a vote could prompt a reappraisal of the potential path for UK interest rates, while also providing a knee-jerk boost to GBP. However, we feel that the economic uncertainty brought about by Brexit will likely lead the MPC to hold fire until there is much greater clarity in the UK's post-Brexit investment environment - which may not transpire until the turn of the year. Moreover, even if we do see last August’s emergency rate cut reversed at some point over the next six to twelve months, our message would be that it is unlikely to mark the start of a pronounced tightening cycle.
As we flagged last week, the GBP trade-weighted index hovering above the 74 level - and close to historic lows - had entered a territory that may require greater attention from policymakers (the BoE's "danger zone"). While the trade-weighted index has rebounded sharply to above 75 over the past week, we acknowledge that were it to stay at these depressed levels, then in isolation, it will result in an upgrade to the BoE's inflation projections at the next forecast round in November.
We wouldn't be surprised to hear greater BoE noise over sterling weakness at this week's meeting, primarily in terms of what this means for inflation overshooting the 2% target and whether the growth-inflation policy trade-off has altered for some MPC members. The following subtle changes in the statement could signal that the balance of risks may be tilting towards an earlier than anticipated withdrawal of the post-Brexit emergency monetary stimulus:
Overall, we believe that such "weak pound" references in the context of BoE policy talk could draw a line under any significant GBP-selling pressures in the near-term.
We attribute GBP's weakness since the August BoE meeting to a narrower focus on upcoming Brexit and domestic political risk events, as well as markets adjusting to a weaker UK economic outlook. Both factors now look to be adequately priced into the currency; as the below chart shows, the relative cyclical and risk premium channels were the biggest contributors to GBP's pronounced weakness against the EUR earlier this summer.
However, with ECB QE speculation priced into the EUR and UK political risks unlikely to notch up another gear in the immediate future, we're now starting to see the overshoot in EUR/GBP unwind. We believe that a hawkish surprise at this week's BoE meeting could fuel a further correction towards - and potentially below - the 0.90 level. This would reinforce our broader view that a EUR/GBP move towards parity remains very much a longshot at this stage.
The bottom line is that while GBP had a fairly dismal August, we believe the combination of more robust UK inflation signals in the latest round of CPI and labour market data releases - as well as a hawkish tilt at the September BoE meeting - could mark a positive turning point in GBP sentiment. Our BoE scenario analysis below shows that the extent of GBP's initial recovery this week will be a function of how much, if at all, short-term UK rates move higher. But in the absence of any further escalation in UK political risks, we look for GBP to embark on a broader corrective phase over the next couple of weeks.