BoE’s Carney Has Two Choices

Investors are jaded with central bank decisions, yet in a matter of three-weeks the Bank of England (BoE) this morning readdresses the fallout of the historic Brexit decision.

Recent U.K data has been dismal – reports point to slumping growth this quarter. In July, BoE official’s surprised investors by keeping overnight rates unchanged, but signaled they would instead loosen this month. In a few hours the MPC will publish their first full assessment of what the Brexit vote means for the U.K economy and their defensive plan.

Currently, the overwhelming consensus expects the BoE’s benchmark rate will be reduced to a new record low (+0.25%) and most predict other measures as well. Options for doing more include expanding the BoE’s +£375B QE program, by buying assets such as corporate bonds, extending credit easing or even giving policy makers longer to achieve their inflation target.

Whatever happens, it’s clear that the market has high expectations, with fixed income traders pricing in a +100% probability of a rate cut. The market is even speculating that there is more in the offering, and have pushed five, ten and 30-year gilt yields to new record lows over the past fortnight.

Since June 23, sterling has fallen about -11% outright and yet the market remains downbeat on the pound. CBOT data indicate that speculators have increased their ‘bearish’ bets on the currency to a new record.

Options for the BoE

After telegraphing the market that something is coming, Governor Carney has two options; he can either throw the “kitchen sink” at his problems or take it slow with incremental monetary policy adjustment. A third option of doing nothing is not a choice, as the “old Lady” will lose all forms of market credibility.

July’s hesitant approach would suggest that BoE might favour achieving maximum results with many small steps, rather than implementing the “hammer” approach. With a number of central banks seemingly running out of monetary policy ammunition, like the BoJ, U.K policymakers will be able to keep their ‘powder dry’ by refraining from further measures.

In this scenario, and with the markets record short position, investors could see the pound (£1.3290) trade higher. Whether this strength lasts depends on whether further easing is signalled in the Carney’s press conference at 07:30 EDT.

Carney’s alternative approach would be to deliver a substantial package of easing measures – a -25 bp rate cut to +0.25% and an increase of +£50-75B in QE via the ‘Funding for Lending’ scheme while maintaining a very “dovish” with the governor signalling readiness to ease further in his press conference.

In this scenario, GBP would weaken against the EUR (€0.8355) and the USD (£1.3290) despite the historic short positions. Its fall from grace should be orderly, back towards Brexit pound levels.

For the “non-positioned,” over the past five-trading days we have seen two central bank decisions (RBA and BoJ) announcing further easing measures, and yet both their currencies (AUD and JPY) have managed to ‘appreciate.’ Perhaps a short squeeze higher will provide much better levels to become ‘bearish’ the pound?

Update:

The BoE announced a larger-than-expected package of measures designed to cushion the U.K. economy against what it expects to be sharp falls in business and housing investment in the wake of June’s vote to leave the European Union.

To ensure the rate cut is passed on to households and business, it also launched a new Term Funding Scheme (TFS) that will provide loans to banks and building societies at rates close to the Bank rate.