Sterling Unwinds Most of BOE-Inspired Gains, but Rates Market Does Not

Sterling peaked on September 20 near $1.3660.  It traded to nearly $1.3220 today.  It has fallen in nine of the past dozen sessions.   The main culprits are the broader US dollar recovery, disappointing UK data, and perhaps some Brexit anxiety, spurred by the continued hardline push by Johnson.  

With today's loss, sterling had practically returned to the lower end of the range seen on September 14 when the minutes and comments around the MPC meeting was considerably more hawkish than expected.  While the currency has corrected, interest rate expectations remain elevated.  The implied yield on the December short-sterling futures contract rose from about 38 bp at the start of the week that the BOE met to  56 bp on September 20, when sterling peaked.  The implied yield currently is near 53 bp.  

In fairness, sterling's advance did not begin with the hawkish BOE, but the latest leg up began in late August when sterling was trading near $1.2775.  The central bank's hawkishness came late in the advance and market only the final leg of it.  The decline over the better part of two weeks has retraced 50% of the gains since late August (found near $1.3215).  The 61.8% retracement is near $1.3110.  

Adding to the negative technical tone is the five-day moving average falling through the 20-day average for the first time since early September.  Trend following and momentum models often using some combination of moving averages and we use the five and 20 as a broad proxy for such participants, even though they may use other moving averages, and in combination with other indicators.  Looking at the other technical indicators, we see the Slow Stochastics have turned down hard, while MACDs have crossed over more recently.  That said, if sterling met the 50% retracement objective of the rally from late-August, it could post some corrective gains.  The initial target would be around $1.3350, which corresponds to last week's lows. 

According to Bloomberg's interpolation from the OIS suggest the market is pricing in around almost an 85% chance of a rate cut before the end of the year, with November 2 favor.  On September 20, when sterling peaked, the odds, according to Bloomberg, stood near 75%.  The  September manufacturing and construction PMI disappointed this week.  Tomorrow, the services PMI will be reported.  If it too disappoints, the market may begin to adjust its interest rate wager.  

Part of the challenge is that the economic cycle and the price (inflation) cycle are not perfectly in sync.  While the UK economy has gradually slowed and continues to do so, inflation has not peaked.  It still seems reasonable that it does peak here in Q4 as last year's sharp sterling fall drops out the year-over-year comparisons.  

As we have noted, nearly every year, but 2016, since Carney took over the helm of the BOE, he has threatened that an rate increase may be needed, and if rates do go up they will be gradual, but more than the market may be expecting.  Last year, after the referendum, the BOE eased policy, by cutting interest rates, resuming its asset purchase and several other measures.   It is possible that the MPC judges that such accommodation is no longer needed.  It is, though awkward to take back the accommodation as household purchasing power is being sapped and the economy appears to be slowing.  The contraction in July service spending in the UK, reported last week is worrisome sign. 

Meanwhile, Brexit issues continue to percolate.  Johnson pushes for a hardline and then capitulates to the Prime Minister's position.  Today, the European Parliament confirmed the impression from the EU negotiators, which despite May's recent speech and the formal suggestion of a transition period, the talks are not ready to proceed to the next phase.  Specifically, the European Parliament voted 557 to 92 (29 abstentions) to postpone starting the new phase at the EU Summit on October 19.  

Ironically, some in the UK government reportedly hoped that if the FDP were part of the new German government, Brexit negotiations could go a bit easier.  It does look like the FDP will be in the governing coalition, and it might even get to have one of its members, perhaps the party leader, replace Schaeuble as finance minister.  However, it is not clear, and won't be for some time, whether the FDP changes the EU's negotiating position.  

Speculative positioning in the futures market is skewed by the contract roll (from September to December), but as of last Tuesday, the speculators were net long sterling in the futures market for the first time in nearly two years.  At the end of August, speculators were net short 51.6k sterling futures contracts.  As of a September 29, they were near long nearly 5.1k contracts.  In the latest reporting week, speculators covered 11.6k previously sold contacts.  The gross short position fell by a third to 75.1k contracts over the past two reporting period.  The speculative gross long position rose from 60.1k at the end of August to 80.1k as of last Tuesday.  It is the largest gross long position I three years.  The large short speculative sterling position that may have discouraged new shorts earlier has been corrected.  

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