Fluid US and UK Rate Expectations

The Federal Reserve and the Bank of England have been relying on forward guidance to help shape investors' expectations for the policy outlook. Because the Federal Reserve is gradually slowing its asset purchase program, it has not had to rely as much on forward guidance as the Bank of England.

For its part, the Bank of England has been struggling to provide a consistent signal. The problem began with Carney's Mansion House speech in the middle of June that warned investors against complacency. This hawkish signal sent the March 2015 short-sterling futures contract sharply lower. The implied yield jumped from 95 bp to 120 bp in sessions. Rates have been gradually trending lower since, albeit choppily, being whipsawed several times over the last two months by "temporally inconsistent" official comments.

With today's quarterly inflation report, the damage inflicted by the Mansion House speech has been completely unwound.  The implied yield of the March 2015 short-sterling futures contract stands at 89 bp. It is slightly lower than when Carney warned against under-estimating. The OIS curve suggests expects for the first rate hike have been pushed from February 2015 to May. The risk is that the pendulum of market sentiment is swinging too far again.

Two events next week could prompt the pendulum to beginning correcting: the July CPI data and the minutes from this month's MPC meeting. Unless prices fell in July, the year-over-year rate is likely to tick up from the 1.9% pace seen in June. More importantly, some economists have warned that there may have been a hawkish dissent at the MPC meeting. We have been a bit skeptical but recognized the risk. The recognition of this risk may also deter investors from pushing the March short-sterling futures contract much lower.

Sterling, which had been a market darling, precisely because of the anticipated trajectory of monetary policy, has fallen out of favor. It is slipping below $1.67 for the first time since mid-April. It is off a nickel from the high set a month ago. As of August 5, the gross speculative long position in the futures market stood near 66k contract, which is a third off the high seen in mid-June. The gross short positions have risen by 20% over the past two reporting period. The net position has been positive, even as speculators become increasingly short the euro, Swiss franc and yen.

Although today's price action, a large outside down day in sterling, will not be captured in the next Commitment of Traders report (the latest reporting period ended yesterday), we suspect that longs are bailing out while new shorts are been established. When the uncertainty over next month's Scottish referendum is added to the mix, a further sterling losses are likely.

The next immediate target is $1.6630, but if that $1.72 high is significant, and we think it is, over the somewhat longer-term, a move toward $1.6300 and possibly $1.60 are not unreasonable.

The US retail sales report has effectively offset the ISM and regional Fed surveys that showed the economy may be accelerating into Q3. The May and June figures were revised lower, and this (coupled with the inventory data) will prompt some economists to expect downward revisions to Q2 GDP (~3.6%-3.7%). Despite the continued job growth of more than 200k a month, retail sales continue to trend lower. The three-month average of 0.2% is the lowest since February.

The yield of the June 2015 Eurodollar futures contract today is matching the lowest level of the past two months near 50 bp. This represents about a 15 bp decline since the end of July. Similarly, since the late July peak near 58 bp, the 2-year Treasury yield has fallen 16 bp to 42 bp now.

Investors are confident that the Federal Reserve will complete its asset purchase program in October. Fed officials first had to convince the market that tapering was not tightening. Then it had to convince the market that there would be a “considerable” period between the end of QE and the first rate hike.

Yellen’s ill-advised attempt to define “considerable” as around six months sowed some confusion, but an April 2015 rate hike, at this juncture, would be surprising. We still think that a more likely time frame puts the first hike near the middle of 2015.

Many investors have also turned their attention to the terminal rate, or where the Fed funds cyclical peak. One aspect of the debate is whether the real Fed funds rate, i.e., adjusted for inflation, turns positive in this cycle.