Carney's Challenge

The Bank of England presents its Quarterly Inflation Report tomorrow. In addition to providing an update of its economic forecasts (likely revising up its GDP forecasts), the BOE is expected to provide, as requested from the Chancellor of the Exchequer, a review of its forward guidance and the trade off between growth and inflation.

In July, at his first MPC meeting, Carney broke precedent by issuing a few remarks after the stand pat policy decision. He made a gentle protest of the backing up money market yields, saying that the "implied rise in expectations of the future path of the bank rate is not warranted by economic developments."

The market responded accordingly. The implied rate of the December 13 short sterling futures contract fell from 65 bp on July 3rd (the day before Carney's remarks) to 50 bp. The implied yield on the December 14 short sterling futures contract fell from 94 bp to about 63 bp. Both contracts have moved broadly sideways in recent sessions, with yields rising in recent days amid the upside data surprises.

Therein lies Carney's challenge: how to preserve a rate environment conducive for a continued recovery in the UK economy without fueling new price pressures.

UK July CPI figures will be reported next week (Aug 13). In June, the headline rate was running at 2.9% year-over-year pace, the highest since last April. The base effect will work in the BOE's favor in H2 13. Monthly prints were averaged 0.3-0.4% in H2 12. These will drop out, especially starting with August reading, though price pressures will remain sticky compared with the other high income economies.  

The recent string of economic data suggest that the British economy has gained some traction.  Nearly every piece of economic news, from surveys and consumer confidence to industrial production, retail sales and house prices have generally been better than expected, and showing sequential improvement.    The economy is points to record its best growth this year since 2007.   That said, even after this performance, the UK's economy will be smaller than it was at its peak. 

A Bloomberg survey conducted last month found  23 respondents expected Carney to link the low interest rate environment to economic conditions (such as an unemployment threshold or, less likely nominal GDP) and 18 expected  the forward guidance to be cast in terms of time (as was the Bank of Canada's), such as interest rates will  remain low through 2014. 

However, should the Fed begin to taper later this year and UK data continues to improve, it will be difficult for forward guidance alone to effectively prevent a backing up of UK rates.  Renewed gilt buying is a possibility, but we would not regard it as the most likely scenario.   Nor will Carney find much in the trade-weighted exchange rate to ease monetary conditions.  The BOE's broad trade-weighted index is in the middle of its four year range (77-84).  A weaker currency appears to push up imported inflation more than it stimulates demand for exports. 

We think caution of a surprise by Carney has prevented sterling from benefiting from the improved economic data and the modest backing up of interest rates.  Barring, then, a significant surprise from Carney, we suspect sterling could trade higher; recover further against the euro, where the ECB is likely to keep rates low for longer (and risk renewed tensions after the summer holidays and German election).  Against the dollar, sterling can test the late July high near $1.5435. A break of that area, which also corresponds to a retracement objective from the June 17 peak near $1.5750 would likely encourage a test on the 200-day moving average seen near $1.5545.  

In terms of speculative positioning, we note that the gross long position in the  CME futures market is the smallest since early last year.  The gross shorts are near 70k contract, which while well below the record high set earlier this year (~111k contracts) remains elevated.  The position adjustment in the euro and Swiss franc have adjusted more, with the net position of both of those threatening to swing to the long side.  The net short sterling futures position is the third largest, behind the yen and Australian dollar.