BOE and ECB: What it Means and What is Next

The Bank of England, which has a penchant for surprising the market, choose not to wait for the quarterly inflation report to provide cover, and announce GBP75 bln additional bond purchases over the next four months. Although many recognized it was possible, only 11 of 32 economists surveyed by Bloomberg expected the asset purchases to be announced. Moreover, the recent data, which included stronger than expected manufacturing and service PMIs seemed to discourage the undecided. It will buy GBP25 bln of gilts across a range of maturities in three weekly auctions.

Previously the BOE bought GBP200 bln gilts between March 2009 and Feb 2010. Six months ago, many observers had expected the BOE to have to hike rates in the face of the persistence of inflation above target. Indeed inflation remains above target. The 4.5% headline of CPI in August matches the peak since the late 2008 and Lehman's failure. Nor is it clear that UK inflation has peaked. Many expect inflation to peak nearer 5%.

The fact that the BOE announced the new bond purchases, even though all but Posen opposed it last month, suggests a significant deterioration in economic and financial conditions. The asset purchases announced today will keep the BOE occupied into the middle Q1 12. The BOE said it will keep the size of the program under review. We suspect the program will be extended if either domestic or international conditions deteriorate. The UK's base rate remains at 0.5%, but do not expect it to be cut unless the UK economy is poised to contract.

We forecast sterling to finish the year near $1.50. However, in the near-term there is scope for additional position adjusting. A move above the $1.5500-50 area could target $1.57 before sellers re-emerge.

The ECB focused on liquidity measures, including a 12- and 13-month long-term refi operations and 40 bln euro covered bond purchases. The ECB did not cut rates as many had expected. Short-term European rates back up smartly, with the euribor futures strip yields rising 9-13 bp.

This has also produced a sharp widening of the US-German 2-year spread which the euro continues to track. On Tuesday Oct 4, the spread was a little more than 20 bp in Germany's favor. Today following the ECB meeting it has risen to 36 bp, a level not seen for a couple of weeks.

The euro initially sold off to new session lows before surging. The euro proceeded to rise above yesterday's high (~$1.3384). Technically this is potentially a key reversal and warns that the large short euro position established by trend followers and momentum traders are risk. A short-covering euro rally, encouraged perhaps too by talk of new European bank support (on the national level), could carry the euro toward $1.36-$1.37 before it falls out of favor again. We expect the euro to finish the year near $1.29.

The ECB did not exactly rule out a cut next month. In fact, by not saying that rates are "accommodative", some observers will conclude that a rate cut next month is in fact likely. However, we are more cautious. It will be Draghi's first meeting as president of the ECB. It would seem unpolitic for him to cut rates at his first meeting. Instead, we suggest that he will likely seek the cover that will be provided in December when the ECB staff provide new inflation and growth forecasts.

One of the reasons we suspect that the majority (the rate decision was on made on the basis of consensus not unanimity) did not favor a rate cut today is that the preliminary report for Sept indicates that inflation ticked up to 3% from 2.5% in Aug on a year--over-year basis. This is a new cyclical high for the euro zone. In order for Draghi-led ECB to cut rates we suspect it would be most helpful if inflation pressures subsided. The short-term and longer-term fallout from the ECB cutting rates with inflation rising could be substantial in terms of credibility.