Pound Continues To Push Higher As Carney Fails To Rein In Bond Market

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 |  Includes: FXB
by: Dr. Duru

In last week's Inflation Report, Bank of England governor Mark Carney tried his best to spin the good economic data in the United Kingdom as evidence that interest rates need to stay low. The current recovery is gaining momentum, but it is nowhere close to where it needs to be:

A renewed recovery is now underway in the United Kingdom, and it appears to be broadening. While that is certainly welcome, the legacy of the financial crisis means that the recovery remains weak by historical standards, and there is still a significant margin of spare capacity in the economy. This is most clearly evident in the high rate of unemployment.

With unemployment still high, the Bank of England, through the Monetary Policy Committee (MPC), wants to maintain low rates for the economy even as economic conditions improve. To this end, the MPC established forward guidance for policy to reassure markets of the accomodative policy presumably required to keep the economy on a sound footing:

The MPC intends, at a minimum, to maintain the currently exceptionally accommodative stance of monetary policy until economic slack has been substantially reduced, provided that this does not put at risk either price stability or financial stability.

In practice, that means the MPC intends not to raise Bank Rate above its current level of 0.5% at least until the Labour Force Survey headline measure of unemployment has fallen to a threshold of 7%. While the unemployment rate remains above 7%, the MPC stands ready to undertake further asset purchases if further stimulus is warranted. But until the unemployment threshold is reached the MPC intends not to reduce the stock of asset purchases from the current £375 billion.

At the same time the Bank of England produced a forecast of unemployment, the first time ever for the Inflation Report, that pegs unemployment at 7.3% after three years assuming that Bank Rate remains at 0.5%. Unemployment is just as likely to reach the 7% trigger before or after three years. Essentially, the message is that monetary policy must remain accomodative around another three years to sustain the current economic recovery. It is a neat communications trick, but it is not likely working as planned.

The chart below from The Financial Times shows that a week later, UK bond yields are higher across the long-term yield curve.

Click to enlarge

UK bond yields continue to increase

Source: The Financial Times

Yields are also slightly higher than a month ago which was right after Carney smacked the British pound down after inserting commentary into the last rate decision that bond yields had gone higher than warranted by existing economic conditions. With UK bonds (gilts) at their highest yields since October, 2011, the British pound (NYSEARCA:FXB) has understandably continued its rally from recent lows:

Click to enlarge

The rally in the British pound continues as yields rise

Source: FreeStockCharts.com

Note that the parallel rise in rates in the U.S. means that the pound is not rallying as much as it could. So, if for example, the Federal Reserve manages to navigate lower rates right through the bond tapering "scare" for next month, the pound could really take off. The Bank of England would then feel the pressure to get creative again in convincing the market to bring UK rates back down. For now, the pound has yet to even log a 2-month high, much less a high for the year. Plenty of upside remains if current conditions continue.

As I mentioned in my last forex piece, I pared back most of my long position on the pound in anticipation of a rally in the U.S. dollar (NYSEARCA:UUP) that would impact all the currencies in the index. I will not rebuild the position at higher levels (I hate chasing rallies) and instead continue to prefer loading up on sell-offs as long as the overall UK economic data continue to demonstrate encouraging signs.

Be careful out there!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: In forex, I am net long the British pound.