Tomorrow’s Bank of England meeting is one of the most important events this month. Back in July, U.K. policymakers made their plans to ease in August abundantly clear and now that the time has come, sterling has been surprisingly stable. By giving investors sufficient warning, the market had the opportunity to completely discount a 25bp rate cut and the question now is if the BoE will do more. They could cut interest rates by 50bp or they could combine a quarter point cut with renewed bond buying. Quantitative Easing was a critical part of the BoE’s monetary policy during the financial crisis but with interest rates already so low, the effectiveness of QE is in question. Many economists believe they will revive the program but not this week. Since Britain decided to leave the European Union, the Bank of England has taken major steps to stabilize the financial markets and encourage lending – and so far it has worked! Stocks are stable, yields have increased and the doomsday sentiment in the market is fading. A lot of this has to do with the U.K. government’s decision to postpone invoking Article 50 for the next year or two, reducing the immediate risk for businesses. This means the central bank can wait to ease again when there is a greater evidence of a deep contraction in the economy.
Taking a look at the table above, there’s certainly been more deterioration than improvement in the U.K. economy since the July monetary policy meeting. However wages are up, the unemployment rate is down and consumer prices are ticking higher. Second quarter GDP growth was also better than expected. Although manufacturing, services and the composite PMI indices fell sharply in July, this morning’s numbers were not revised lower after the flash release. When the Bank of England releases their Quarterly Inflation Report tomorrow, their forecasts will be grim – policymakers previously warned of a possible recession post Brexit. Governor Mark Carney won’t have anything positive to say outside of acknowledging financial market stabilization. Yet economic and financial conditions are not desperate enough for the Bank of England to rekindle their QE program.
In other words, we feel that the Bank of England doesn’t need to send a strong message to the market right now outside of a 25bp rate cut and a stern warning of more easing in the coming months. If we are right, we could see a bigger short squeeze in GBP/USD that will allow investors to reset their short positions at higher levels. The U.K. is not out of the woods, as growth will only slow further in the coming months / years because the U.K. government is simply delaying the inevitable. If they cut by 50bp or restart their bond buying program, sterling will fall quickly and aggressively.
Both the Bank of England and the European Central Bank will be making monetary policy announcements on Thursday. The market expects the ECB to remain on hold and BoE to increase their asset purchase program by GBP 50 billion. A quick look at the following tables explain why the BoE is expected to ease and the ECB is not. Since the last monetary policy meeting, Eurozone economic data was neutral / mixed to bullish. U.K. data on the other hand was neutral / mixed to bearish.
The New Year has begun and it is important to see what the market is pricing in for central banks this year. As you may know, central bank rate hike expectations change often but as of last week, most central banks are expected to keep monetary policy unchanged in the coming year but one is expected to ease aggressively. Find out who below!
Federal Reserve – No Changes in 2012
European Central Bank – Possible 25bp Cut before Year End
Bank of England – No Changes in 2012
Bank of Canada – No Changes in 2012
Reserve Bank of Australia – Aggressive Rate Cuts this Year, 25bp by March!
Reserve Bank of New Zealand – No Changes in 2012
And here are the details!
The Euro and British pound have come under severe selling pressure after the ECB and BoE cut interest rates by 50bp. Interest rates are now at historic lows for both central banks and even though the rate announcements were negative for both currencies, the Euro has sold off more aggressively than the British pound because ECB President Trichet warned that growth will be signicantly reduced in 2009 and 2010 while inflation will remain well below 2 percent.
More importantly, he admitted that the ECB is studying non-standard measures which include quantitative easing. However, Trichet prefers to use the Fed’s label of credit easing over quantitative easing (What is the Difference Between Credit and Quantitative Easing?). The mere possibility that the ECB could consider Quantitative Easing was enough to drive the EUR/USD below 1.25. With the third highest interest rate of the G10 nations, further interest rate cuts are still possible. By saying that they have not made a decision about whether 1.5 percent is the lowest level makes 1 percent interest rates a real possibility for the Eurozone. In fact, Trichet may opt for another rate cut before credit easing. For the US dollar, British pound and Japanese Yen, no surprises are expected from future rate decisions. However for the Euro, the prospect of lower interest rates and the uncertainty of if and when the ECB will adopt credit easing should keep the EUR/USD under pressure.
Bank of England: Rates May Have Hit Rock Bottom
As for the Bank of England, I believe today’s 50bp rate cut to 0.5 percent is their last. The central bank has been worried that excessively low interest rates would erode profitability of banks, reducing their incentive to lend. Now that they have been given the authorization to begin Quantitative Easing, it will be their new focus. UK Gilts have soared on the announcement that the government will purchase up to £100bn in Gilts and £50bn in private sector assets (syndicated loans and ABS). As we indicated in our ECB and BoE preview, Quantitative Easing is negative for a currency, but if the BoE is done cutting interest rates, further weakness in the British pound may be limited.
Update – 5 Reasons Why the British Pound is Being Pounded – Access my latest article Feb 28, 2010
How Did the British Pound Trade in 2008?
The British pound was one of the worst performing currencies in 2008. It fell to a 6 year low against the US dollar and record low against the Euro in addition to selling off against every other G10 currency. The overwhelming weakness in the currency is a direct reflection of the impact that the credit crisis had on the UK economy. In the month of December, many currencies recovered against the US dollar, but unfortunately the British pound was not one of them. Although the pound could continue to weaken in the first quarter, the government’s aggressive fiscal and monetary stimulus should help the country recover towards the end of 2009.
Official Recession in 2009
Without two consecutive quarters of negative GDP growth, the UK economy is not technically in a recession but that should change in the first quarter of 2009, when the 2008 Q4 GDP numbers are released. Growth has been slowing materially and the weakness is reflected in the British pound. GDP growth fell by 0.6 percent in the third quarter, the largest decline in 18 years. The housing market and the financial sector have been the engine of growth in UK for the past few years and both blew up in 2008. Unfortunately the worst is probably not over for the 2 key components of the UK economy, particularly following the Bernie Madoff’s Ponzi scheme. In addition to losses suffered from the subprime mortgage crisis, many large hedge funds and European banks invested with Madoff’s. In 2009, they will be forced to write down those losses and deal with what could be pretty severe consequences for the financial sector as a whole. With the financial and housing market sectors expected to remain weak in the first half of 2009 and layoffs predicted to rise, GDP growth could fall as much as 2 percent next year. Although we believe that the country could be one of the first to recovery from the global economic downturn, this will not before more pain is felt in the UK economy. The severity of the UK recession will be largely dependent upon how quickly the credit markets are restored in 2009.
Inflation to Fall Back to 2%