The Bank of England's Quarterly Inflation Report will be released tomorrow, followed by comments from Governor Carney. He is expected to signal that despite the 7.0% unemployment threshold being approached, the recovery needs to strengthen and there is sufficient spare capacity to allow this to happen without posing inflation risks. Interest rates can stay low for longer.
The market has taken this view on board. The implied yield of the March 2015 short-sterling futures contract has fallen from 1.10% as recently as January 22 to 0.84 bp yesterday. It seems unreasonable to expect much more of a decline. There is a solid floor near 80 bp that goes back to last October. In terms of short-sterling, there is a risk of a buy the rumor sell the fact kind of activity in response to the BOE's inflation report.
We expect such a rise in UK yields to help lift the sterling. A move above $1.65 will brig the multi-year high set on January 24th near $1.6670 into view. Speculators in the CME futures, a proxy for trend followers and momentum players, have been scaling out of long positions in recent weeks. In fact, the net long position was halved in the reporting period that ended February 4. It now stands at a three-month low. The gross shorts were cut by a little more than 11k contracts, the largest adjustment since July, and have been reduced by nearly a third since early December.
Making a virtue out of a necessity, Carney will update the forward guidance. It seems unreasonable to expect it to be jettisoned as some have suggested. It has nothing to replace it with. The Bank of England believes it needs to help guide investors during this unprecedented period of low interest rates and still fragile economy.
At the Bank of Canada, Carney's forward guidance was focused on a time frame rather than macro-economic data. It seems unlikely he will revert to such a strategy now. When the 7% unemployment threshold was first announced, the BOE did not think it was likely until 2016. In the three months through November, it averaged 7.1%. Carney could simply reduce the threshold to, say, 6.5%. However, this simply begs the question and may paint the BOE into a corner if the unemployment rate falls to 6.5% before the MPC wants to hike rates. It would be forced to change the threshold again at a cost of credibility.
Carney could broaden the range of variables the BOE uses as a threshold. The BOE's economist had indicated at the end of last year that the February Quarterly Inflation Report could contain more quantitative information about how the BOE analyzes the economy and inflation. While it is possible to have inflation without wage pressures, as the UK has recently experienced, the low earnings growth speaks to slack in the labor market, which in turn says something about the fragility of the UK recovery.
Although the recent string of PMI reports showed some moderation in economic activity, the recovery remains intact. Like-store sales rose 3.9% in January, the largest increase since April 2011. It follows a 0.4% increase in December. and compares with expectations for a 0.8% increase. Just yesterday, CBI revised up this year's GDP forecast to 2.6% from 2.4%, while cutting its inflation forecasts to 1.9% from 2.5%. It does not expect the first hike by the BOE before Q3 2015.
Next week, the UK reports CPI figures and the risk is that inflation ticks up, supporting our idea of higher UK rates (and a stronger sterling). Recall that last January UK CPI fell by 0.5%. This will drop out the year-over-year comparison and likely lift the rate from the lowest level since late-2009 (2%). It may be a bit of a statistical fluke and may be unwound in February, when in 2013, CPI jumped 0.7% on the month.