Bank of England puts rocket under GBP, but its credibility is on the line
The Bank of England is reviving GBP’s fortunes by indicating that UK interest rates could rise before year end as inflation is above target. But this is far from assured and the central bank could damage its credibility.
In the meantime, GBP/USD is seeing some of its highest levels since the Brexit referendum result and while the market buys this narrative a move towards 1.3800-1.4000 is entirely feasible. But the Bank’s messaging has been inconsistent and if it intends to raise interest rates this time – then it needs to follow through unless an economic shock happens in the interim.
Back in June at a conference in Portugal, BoE governor Mark Carney joined the global central bank chorus over intensions to normalise sluggish monetary policy signalling that a UK rate rise was on the horizon, then backed-off on economic data. Last week, the Bank once again dropped strong hints that the UK is set for rising interest rates.
This might be partly to address the Bank’s over-reaction to the Brexit vote last year when it provided extra liquidity to commercial banks to keep lending – a good move, cut interest rates by 0.25% -- debatable, and to restart quantitative easing, which looked unnecessary. No doubt this was in response to its overly bleak expectations for the UK economy in the immediate aftermath of the Brexit vote. In the event the economy did not tank as the existing momentum continued rather than being entirely down to the BoE’s stimulus efforts.
However, increasing interest rates now is a risky strategy. The economy is sluggish as consumers appear to be maxed out. Making credit more expensive could slow domestic consumption further and edge the UK towards recession. Also, as Brexit beckons on March 2009, an event the BoE believes will have a material impact on the economy, raising interest rates seems like a strange thing to do – unless a transitional trade agreement is negotiated between the UK and EU (a still uncertain prospect).
But inflation, running at 2.9%, is consistently above target due to GBP’s devaluation rather than domestic factors such as wages. A lift in sterling would alleviate inflationary pressures and would help restore consumers’ purchasing power. A one-off lift in rates to 0.5% and an ending of QE might achieve a firmer GBP without snuffing out growth – if it is billed as an ending of emerging stimulus. All eyes will be on the November 2 meeting.
Meanwhile, politics will continue to make the Bank’s job difficult. Prime Minister Theresa May is due to give a speech in Florence on Friday where she is expected to try and nudge the Brexit negotiations forward. If she signals compromises – a dangerous move given her largely Eurosceptic party – it could push up GBP even further. Also, UK economic data will influence trader views on GBP with retail sales data due on Wednesday.
Much of GBP’s recent rally is likely to have been on short-covering. According to data from the Commodity Futures Trading Commission on Sept 12 the futures markets were still net short on GBP.
In the meantime, GBP remains shrouded in uncertainty and is still vulnerable to set-backs, particularly if the BoE doesn’t follow through on its hawkish statements with the risk of it being seen as “all mouth and no trousers” by the markets.
TECHNICAL ANALYSIS – GBP/USD due for a pause
With the prospect of firmer UK interest rates and a weak USD, GBP surged last week leaving technical indicators over-stretched. A pull back is in order. Meanwhile, the pair moved into the huge gap created by the vote to leave the EU last year at 1.3533-1.4012, which could be bullish.
Meanwhile, the pair are well above the 200 (turquoise blue) and 50-day (dark blue) moving averages, which is bullish. But shorter term, expect some pull back or consolidation with possible tests to levels around 1.3400-1.3500. The daily RSI is well into overbought territory and the dailies are above the upper Bollinger band – both signals that the rally is likely to pause.
Also, the move appears to have been an over-excited reaction, along with short-covering, on news that Gertjan Vlieghe, a dovish member of the BoE’s monetary policy committee, has turned hawkish. Meanwhile, traders should keep a close eye on the data calendar with the FOMC statement due Wednesday, which could be a big mover for USD.
Resistance is pegged at 1.3616, 1.3650, 1.3700, 1.3830, 1.4012 with support seen at 1.3567, 1.3531, 1.3433 and 1.3402.
By Justin Pugsley, Markets Analyst, MahiFX