After artfully fending off questions about the timing for higher interest rates, Mark Carney finally gave the market throngs a clearer hint:
There's already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced. It could happen sooner than markets currently expect…
…The need for internal balance - to use up wasteful spare capacity while achieving the inflation target - will likely require gradual and limited interest rate increases as the expansion progresses. The start of that journey is coming nearer.
Mark Carney, the Governor of the Bank of England (BOE), spoke these words near the beginning and near the end of his address at the Lord Mayor's Banquet for Bankers and Merchants of the City of London at the Mansion House in London on June 12, 2014.
The impact on the British pound (NYSEARCA:FXB) was swift and immediate (I am charting the currency pair and not the ETF given the surge started right after the U.S. market closed):
The pound soars as the market adjusts to more hawkish expectations for interest rates
There is delicious irony in warning that rate hikes could come earlier than expected: Carney and his cohort have lulled us (at least me) into thinking that the BoE is quite reluctant to raise rates anytime soon. In fact, the BoE has seemed more interested in preventing the market from getting a head start on higher rate expectations. Moreover, in the last Inflation Report, Carney seemed to float signals that he preferred a lower exchange rate for the British pound. In late May, I took that as a signal to finally drop my bullishness on the pound, especially given the likelihood of a lower euro (NYSEARCA:FXE) in the face of looser monetary policy from the European Central Bank (ECB). It was a good thing I did not subsequently turn bearish!
I think this surge is a gross over-reaction: the market overly focused on the changed timing of the first rate hike and not the unchanged overall trajectory and scope of those rate hikes. Carney is simply exercising the same caution and discipline he exhibited as the Governor of the Bank of Canada: "We are now faced with the challenge of turning [the] recovery, which has steadily gained momentum and breadth over the past year, into a durable expansion." Carney makes it clear that essentially nothing has changed about the rules the Bank of England will use foster this durable expansion:
…to be clear, the MPC [Monetary Policy Committee] has no pre-set course. The ultimate decision will be data-driven. At this point it is safest to conclude, as the MPC has, that there remains scope for spare capacity to be used up before policy is tightened and that a host of labour market, capacity utilisation and pricing indicators should be watched closely to determine how that slack is evolving.
The economy is racing ahead at an annualized pace of 4% and jobs are growing much more strongly than expected, but the slack in the economy has also proven larger than expected. So work and time remain before the Bank of England will raise rates. When the BoE DOES raise rates, it still plans to move slowly (emphasis mine):
…we expect that eventual increases in Bank Rate will be gradual and limited. That is because the economy will face the ongoing challenges of public and private balance sheet repair, a 10% appreciation of sterling over the past year or so, and muted growth in our main export markets. In addition, in the medium term, higher capital, liquidity and other prudential requirements can be expected to lead to higher spreads between borrowing rates and risk-free rates than before the crisis.
In other words, the BoE still has its eyes trained on the exchange rate and is likely not interested in the market sending the exchange rate much higher.
So then why shake up the currency market with the magic "sooner than expected" language? While the BoE prefers a lower exchange rate, it also sees imbalances in the economy that are partially a result of extremely low implied volatility, excessive debt, and higher than warranted risk-taking:
The economy is still over-levered. The housing market is showing the potential to overheat. And the current account deficit is now at a record level.
There is a delicious irony about Carney's observations on the British housing market. At the last Inflation Report, Carney deftly deflected probing questions from reporters about a potential bubble in the London housing market. Carney has apparently and suddenly found some religion on that score:
There are some signs that underwriting standards are becoming more lax, with the proportion of new mortgages at high loan-to-income ratios now at an all-time high. The increase in house prices in the past year means we can expect the proportion of high loan-to-income mortgages to grow further in the coming year even if the housing market begins to slow. This is concerning because a durable expansion requires mortgages to be serviceable over their lifetime not just when interest rates are at record lows.
On the other hand, Carney is very aware that hiking rates too fast could sink an economy with consumers loaded up on debt from housing and consumption (partially afforded by a higher exchange rate):
…a highly indebted private sector is particularly sensitive to interest rates. Caution over the path of rate increases once they begin is also needed because we start at a point from which interest rates cannot easily be reduced. The effects of an excessive or an excessively rapid tightening of monetary policy could prove damaging and difficult to undo.
Ultimately, I think Carney implied that rate hikes may indeed start sooner than expected, but the overall pace of rate hikes is not likely to exceed expectations:
…financial markets expect Bank Rate to rise to only 2 ¼% over the next three years and, on that basis, the MPC expects the economy to move towards internal balance - almost closing the output gap - in the same period.
In other words, the expected overall trajectory for interest rates remains largely unchanged. Carney and the Bank of England have simply and finally convinced themselves it is time to directly remind the UK that those higher rates are indeed on their way.
While I think the currency market over-reacted to the rate hike headlines, I am NOT recommending selling the British pound. I find it difficult to even guess how long the over-reaction may last. None of the other major currencies I follow features a central bank openly discussing rate hikes in any determined way. Thus, on a relative basis, the pound might look pretty good to traders for quite some time. If I were to buy the British pound, I would greatly prefer to buy it against the euro. It is the one currency I think will continue going lower as the ECB fights to develop a "Goldilocks currency": not too low and not too high.
The euro had already lost its temporary post-ECB relief rally before Carney extended the losses
Be careful out there!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In forex, I am net short the euro