Sterling HOD, FTSE weaker as markets digest slightly hawkish BoE

After a bit of time to digest the Bank of England decision, it looks to have provided that hawkish pivot we’d anticipated. But I would not say it’s enough to really tell the market that it will fulfil its mandate to keep inflation in check and ensure longer-term inflation expectations remain in check. A missed opportunity, I would say, to get a better grip on inflation expectations.

Key points

• MPC votes 7-2 to maintain QE, unanimous on rates
• Ramsden joins Saunders in voting to scale back the QE programme to £840bn, ending it immediately
• CPI inflation is expected to rise further in the near term, to slightly above 4% in 2021 Q4 – and the BoE signalled greater risk it would be above target for most of 2022
• Overall, Bank staff had revised down their expectations for 2021 Q3 GDP growth from 2.9% at the time of the August Report to 2.1%, in part reflecting the emergence of some supply constraints on output
• Shift in forward guidance: MPC noted ‘some developments … [since the August Monetary Policy Report] … appear to have strengthened’ the case for tightening monetary policy.
• Rate hikes could come early, even before end of QE: “All members in this group agreed that any future initial tightening of monetary policy should be implemented by an increase in Bank Rate, even if that tightening became appropriate before the end of the existing UK government bond asset purchase programme.”

Market reaction thus far

• GBPUSD has rallied to highest since Monday off a month low and is looking to hold above 1.37, having risen one big figure today. Needs 1.3740 for bulls to regain control, big test here with trend support recently tested at the neckline. Question is this mildly hawkish pivot is enough to put the floor under GBP. I would still argue for softer dollar into year end allow GBP (and EUR) some scope to strengthen, particularly if the BoE is progressing towards raising rates sooner than previously thought.
• That sterling strength sent the FTSE 100 lower after a solid morning session, leaving the blue chips flat on the session, around 45pts off the highs of the day. Looking now for a lift from Wall St with US futures indicated higher: S&P 500 around 4420, Dow Jones at 34,460.
• 2yr gilt yields jumped to +0.3435% from around 0.28% earlier in the day as markets moved expectations for the first 15bps rate hike forward to Feb 2022.

GBPUSD chart 23.09.2021

Summary view

The BoE trying to tell what we already know without telling us what we already know; ie, that inflation is way stickier than they thought it would be. The BoE said “there are some signs that cost pressures may prove more persistent. Some financial market indicators of inflation expectations have risen somewhat”. Somewhat what? It’s all a bit wishy washy. The problem is the dogma of transient inflation is hard to shake without admitting that they were plain wrong on a very basic assessment of the economic outlook. “The committee’s central expectation continues to be that current elevated global cost pressures will prove transitory,” the statement from the BoE said.

Earlier, PMIs show across Europe and Britain growth momentum is waning, inflation is sticking. The UK composite PMI revealed further loss of growth momentum as output slowed to the weakest in 7 months, whilst the rate of input cost inflation accelerated and charges raised to the greatest extent on record.

Taken together with the PMIs this morning and the Fed last night we are presented with a very simple picture: growth is slowing, supply constraints are deepening, inflation is proving way more persistent than central banks anticipated. This could have important consequences for monetary policy going forward, but for now the CBs are still waiting it out and getting further behind the curve. A bitter pill today has been avoided, but the medicine required will be harder to swallow when it finally comes. Rates are going to need to rise to tame inflation.

FX primer: A big week ahead for the pound?

Forex

• Scottish election: breakup risks?
• Bank of England meeting
• Sterling struggling to recapture 1.40

Scotland’s elections on May 6th combined with a Bank of England (BoE) meeting create a good deal of event risk for sterling crosses, gilts and UK equities next week.

First to the elections, where results will be closely watched by the FX markets for a signal on a possible second independence referendum. Whilst Boris Johnson has been clear on not allowing another referendum in this Parliament, strong SNP support would be considered by Nationalists are a firm vote of confidence and would create impetus behind calls for Indyref2. First minister Nicola Sturgeon says a majority of pro-independence MSPs, which would include SNP, Greens and perhaps any new Alba MSPs, would deliver a mandate for another referendum. I do not want to get into the weeds of polling figures and the permutations of the Scottish regional list ballot system; however, it is worth a quick look at the latest figures.

A Panelbase survey suggests the SNP will fall short of an absolute majority, but pro-independence MSPs would have a majority in Holyrood. The survey points to 61 SNP MSPs (down two from 2016), 24 Conservatives (down seven), 20 Labour (down four), Greens 11 (up five), eight for Alex Salmond’s Alba and five for the Liberal Democrats. A poll by Survation predicted that the SNP is on course to win a five-seat majority. Based on this assumption, and an expected strong showing for nationalists (be they Green, SNP or Alba), it’s likely Nicola Sturgeon will remain as first minister and there will be renewed calls for independence.

Since the Brexit vote and subsequent agreement (now finally ratified), the case for independence has taken on a new tone. Scotland, argue the nationalists, voted to remain in the EU. The 2014 once-in-a-generation vote is irrelevant since things have changed within the UK, they say. Scots said no to independence believing they’d stay in the EU. Such constitutional grumblings are of course non-sensical; Scots voted to remain part of the UK, the UK then voted to leave the EU: that’s life. It’s not a buffet. I daresay my corner of the Chilterns voted to remain, but it is an irrelevance.

Putting all of this to one side, as far as markets are concerned the election in Scotland is ‘one to watch’. UK break-up risks could be a factor in holding sterling back right now. A victory for nationalists could create further unease and is certainly one to watch for GBP crosses in the coming days. However, given the British government’s position, I see no actual risk of a breakup of the UK in this Parliament. Longer-term, Scottish nationalism will continue to act as a headwind to sterling.

Then we have the Bank of England meeting, also on May 6th. Don’t expect any change to monetary policy, however the much brighter economic outlook certainly points to the Bank being able to wind down emergency mode earlier. With QE running at a pace of slightly more than £4bn in gilt purchases weekly, the focus will be on at what point the MPC chooses to signal it will slow this down later this year. The contraction in GDP in the first quarter was not as bad as feared as the economy showed far greater resilience to lockdown 3 than lockdown 1, whilst the success of vaccinations is becoming abundantly clear and means lifting of all restrictions by June 21st is looking more and more likely. The vast majority of economic activity will ‘normalised’ by May 17th. Therefore, there is a risk that the Bank announces plans to taper asset purchases at this meeting, sooner than the market is maybe anticipating. This would likely be positive for sterling since FX markets continue to under-price MPC hawkishness.

The Bank forecast a 4% decline in Q1 (quarter-on-quarter), however the data so far indicates that the contraction was milder than the February projection. Growth estimates for the full year may well be revised higher from the current 5% level. This may provide ammunition for an earlier taper, however the MPC may prefer to wait longer (say June, when the extent of the reopening will be better appreciated) in order to engineer a steeper taper in the second half of the year.

Markets are currently pricing a small hike this year, and 50 basis points over the three years of the BoE’s forecast horizon. While all the chatter was about negative rates, it has become clear that the next move by the MPC will be to raise rates, unless of course we get another exogenous shock.

Ahead of next week’s meeting we have seen some mild tightening as 10yr gilt yields crept higher and we could see tightening further before or around the meeting in anticipation that the BoE does not seek to push back against those market expectations. Teeing up a taper could see the yield on the 10-year gilt rise back to the March peak at 0.87%, which would be sterling positive. Ultimately the question about tightening is really one of timing, but the BoE cannot be blind to the economic data and this meeting could be the time to fire the starting pistol.

GBPUSD has resolutely refused to break out of the week’s range and mount any attempt to scale 1.40. Price action has centred on the 38.2% retracement area at 1.3890. With little appetite to take on 1.40 for now we could see a retest of 1.3860 in the near-term, with a drift to 1.380 and the 23.6% retracement a possible area to look at on a dip. Scottish risks may be put to one side by traders focused on the here-and-now of gilt yields and potential tightening into the BoE, helping to create the conditions for another attempt to clear the big round number. Bullish crossover on the hourly MACD is useful. On the daily chart the bullish crossover from two weeks ago is still in play but momentum keeps fading at the 1.39240 area this week. (daily on the left, hourly on the right).

Chart showing GBP movement against USD.

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