BOE met last week with market participants looking out for a hawkish rhetoric and expectation for the BOE to indicate the future path of tightening. After going through the statement, the inflation report and the press conference there are two main points I found to be most important;
1. While inflation is above the MPC’s target range of 2% and is forecast to reach 3% by the fourth quarter and while the MPC have previously stated that there are limits to the extent to which above-target inflation can be tolerated, monetary policy would only be able to offset the effect of weaker sterling on inflation at the cost of higher unemployment and weaker income growth which would directly impact reflation. It is also noted that wage growth is projected to remain modest in the near term, before recovering further ahead.
2. Current forecasts are dependent on a smooth Brexit. When Carney was asked a question by the Financial Times on how dependant the forecasts are on a smooth Brexit and what the risk would be for a hard Brexit Carney advised that an alternative forecast has not been prepared that takes into account a disorderly exit and that since the August 2016 forecast the MPC has assumed that the exit from the EU would be smooth with a bit of a drag to productivity factored into the forecast as the economy adjusts during the implementation of a new trading agreement. When asked if the assumption of a smooth Brexit is optimistic Carney responded that both the UK and EU are acting according to a mandate to deliver an orderly agreement and it is not the BOE’s place to call those into question and that there is still a long road to walk until Mach 26 2019.
So what does that have to do with the price of Pound – well it’s clear that the BOE expect the exchange rate to settle over the forecast period as the outcome of Brexit negotiations become clear and that during this period wage growth will start to improve which will allow the BOE make changes to monetary policy in line with inflation objectives and without placing further pressure on household income and spending. Of course, any events that equal a disruptive Brexit would place the BOE in a very difficult position because if the exchange rate was to drop and inflation exceeded 3% in Q4 as forecast and the BOE raise rates to offset the effect of weaker sterling on inflation that would create downside risks for the UK economy because household income would have even more difficulty keeping up with consumer prices. Sounds like a pretty difficult spot for UK businesses and investors.
So how does one formulate a bias on Pound?
1. Recent COT data shows that, despite the recent uptick in Pound vs. the USDollar, no one is buying Sterling at the moment and that the recent move higher is just short covering. For three weeks in a row, we have seen Bears taking profit with no increase in Bulls and last week we saw a drop in long positions as well
2. Latest data (retail sales (MoM), retail sales ex-auto, GfK consumer confidence, nationwide housing price and mortgage approvals, FTSE 100 index, Gilt yields) is bearish. Paying attention to next week’s inflation, jobs and consumer reports this week
3. The BOE are not going to tighten any time soon
4. We don’t know what the outcome of the snap election on June 8 is going to be and currently are only able to rely on polls which currently show a 46.6% lead for Theresa May’s conservative party as of 13 May 2017
5. We don’t know how smooth the Brexit negotiations are going to be
6. Pound is still heavily undervalued
None of those points give me a reason to start buying Pound (except to profit off of any further short covering which would be a technical play) and as far as Pound becoming bearish and returning to 1.2350 against the USDollar is concerned (technical analysis shows that this is certainly the May target for Bears) I think that will depend on what happens in the weeks leading up to June 8 and strength or weakness in the USDollar and how resilient Bulls are to get Pound back up to fair market value.
So taking all of this into account it’s quite clear that near-term risks are important to pay attention to. Any news regarding June 8 is going to create some volatility in the market and that a lack of news could result in consolidation until the market has more to go on. As far as safe havens are concerned (JPY and CHF) one would need to take risk sentiment into consideration and pay careful attention to indices and the US10Y yield. Please see my weekly FX outlook for more info and analysis.