The two day meeting of the BOE's Monetary Policy Committee has begun, and there is practically no chance of a change in rates or in its asset purchase program. Nevertheless, the meeting provides a timely opportunity to review the outlook for UK monetary policy.
The last MPC meeting was December 9th-10th. With no dissent, it left the bank rate at 50 bp and maintained its asset purchase program cap of GBP200 billion. It will take the BOE the better part of the next month to complete these purchases, making the February MPC meeting potentially more interesting.
The data since the December MPC meeting has generally been supportive of the idea that the UK economy returned to a growth path in Q4. Nevertheless, the weakness of November retail sales, the sharp drop in Nationwide's December measure of consumer confidence and the sharp backing up of interest rates in the past month illustrate the fragility of the situation.
The 47 bp rise in 10-year UK gilt yields in December complicate the MPC's challenges in terms of its long term asset purchases under its quantitative easing program. On one hand, the purpose of QE in the first place was to contain the rise in bond yields. The rise in bond yields could be seen as evidence that QE is not working. If it is not working, given the amount earmarked (GBP200 billion), and within the context of the other major countries exiting their QE efforts, it is difficult to envisage an expansion of the QE.
On the other hand, the rise in rates could reflect the success of QE if the strategic goal was to help return the economy to growth. If the program has been successful then the BOE can claim victory and join others in ending asset purchases. Hence under both evaluations (spins?), extending QE seems unlikely.
Inflation pressures are rising. It is possible that BOE Governor King is required to write a letter to Chancellor of the Exchequer explaining why inflation is overshooting before the UK election, which has to be held by early June. Although the media reports have played up the decision by several large institutional investors to reduce their gilt exposure, most of the recent rise in gilt yields reflects an increase in inflation expectations not real rates. Specifically, the five-year/five-year forward (a handy proxy for inflation expectations) rose nearly 30 bp since late November.
The end of the emergency VAT cut and other temporary factors may be the main driver of current price pressures, but confidence in policy makers and their ability to create sufficient price pressures to avoid deflation but not sufficient to erode values is not particularly robust. But on balance the inflation outlook also seems to argue against extending QE.
Judging from the pop support for Labour on the government's decision to tax bank bonuses at a 50% rate, UK public opinion appears particularly hostile to the financial sector and additional populist measures cannot be ruled out by a Labour Party still trailing in the polls. There has been widespread talk of dissent within Brown's cabinet, including talk of a pending resignation by a senior minister. There has been a call today by two former cabinet ministers to hold a secret ballot on whether Brown should lead the party into the next election. No alternative candidate has yet been presented and although the call for the ballot may seem like a sign of Brown's weakness, if a ballot were held quickly before the Labour dissents can coalesce around a different candidate, Brown could de-fang his critics within his government by forcing them to endorse him.
While there is no doubt that an election has to be called, Brown will likely seek an element of surprise. There had been talk that an election could be called for March, which could let Brown avoid budget wrangling. Meanwhile, Tory leader Cameron promises that if he leads the next government, there would be a new and tighter budget within 50 days. The potential shifting sands of fiscal policy makes monetary policy all the more difficult in conducting. The movement of sterling itself is of little consequence for the policy outlook currently.
From a monetary policy point of view, a trade-weighted view of the currency is often more important than bilateral exchange rates, and one day moves are not nearly as important as the general trend. The 20-day moving average of the BOE's effective sterling index has risen 2% off the early Oct low, which itself was a nearly 8% decline from the Aug high.
Macro-economic considerations do not appear to be sterling supportive. The FTSE is roughly 70% above March 09 lows and just poking through the 61.8% Fibonacci retracement of the decline from the bull market high in mid-July 2007. Among the G7 the UK's FTSE has been among the laggards in 2009.
Anecdotal reports suggests the institutional investors are not overweight UK stocks or bonds and are not inclined to change this any time soon.
Non-commercials (speculators) in the IMM currency futures have been short sterling on a net basis since August 2008. Although short positions were pared back in November, they have been growing steadily over the past 4-5 weeks, but at about a half of the net short position that was seen in October, the net short position is not extreme enough to give much confidence of a contrarian signal.
Technical indicators also seem sterling negative. A number of observers are monitoring the golden cross/dead man cross--which are the 20- and 200-day moving averages in sterling. The 20-day moving average is poised to fall below the 200-day moving average. The last time that this took place was in August 2008 and sterling subsequently collapsed. The 20-day moving average has been above the 200-day moving average since May.
Momentum and other near-term technical indicators are generating strong signals presently. Near-term support is seen near $1.59, but the low in H2 09 was set in mid-October just above $1.57. On the upside, the high from this week and last week were recorded in the $1.6235-40 area.
Of course, sterling is heavily influenced by the dollar's underlying direction and for many the near-term dollar outlook will be determined by the US jobs report on Friday.
Disclosure: No positions