Dr. Duru's  Instablog

On June 15, Bank of England Governor Mervyn King spoke at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London at the Mansion House. The speech covered very familiar themes for King and the Bank of England.

King first acknowledged the squeeze on the economy in the United Kingdom:

“The challenge facing monetary policy is obvious – the combination of high consumer price inflation and weak economic growth. Both of these might seem surprising given the large amount of spare capacity in the economy. But the rise in world energy and other commodity prices, and the need to reduce both the external and budget deficits, are squeezing real living standards, pushing up on consumer price inflation and slowing domestic consumption.”

This challenge provides plenty of reason for bearishness on the pound. However, it is King’s explanations for maintaining loose monetary policy, comforted by the theme of rebalancing the UK economy, that seal the deal for me.

Over the years, King has consistently hammered on the theme of rebalancing in the UK’s economy: a transition away from domestic consumption and toward exports and the business investment required to support this shift. In Wednesday’s speech, King indicated that the rebalancing underway will continue for several more years. This process has necessitated the devaluation of the currency. King cleverly attributes the devaluation to market forces while indicating the Monetary Policy Committee (MPC) chose not to counter-act the pressures on the currency:

“A necessary precondition for that rebalancing was a fall in the real exchange rate. Markets anticipated that need. The nominal effective sterling exchange rate fell by around 25% between the start of the crisis in 2007 and the beginning of 2009, since when it has been broadly stable…

…We could have raised Bank Rate significantly so that inflation today would be closer to the target. But that would not have prevented the squeeze on living standards arising from higher oil and commodity prices and the measures necessary to reduce our twin deficits. And it would have meant a weaker recovery, or even further falls in output…”

In other words, the MPC decided to focus on the implications of a weak economy over the implications of high inflation, judging the former to be the greater threat. In doing so, King has frequently noted that today’s high inflation is temporary, thus rationalizing on-going accomodative monetary policy and low interest rates in the face of high inflation. The primary blame for high inflation has shifted from hikes in taxes (the Value Added Tax or VAT) to commodity and energy prices, both presumably out of the control of monetary policy. Internally, conditions do not exist for sustaining “domestically generated” inflation:

“So far, subdued rates of increase in average earnings, as well as remarkably – some might say disturbingly – low growth rates of broad money have provided strong signals that inflation will fall back in due course. Banks are still contracting balance sheets and reducing leverage. Spreads between Bank Rate and the interest rates charged to many borrowers remain at unprecedentedly high levels, if indeed borrowers are able to access credit at all.”

King really caught my attention when he provided two key conditions that would actually compel rate hikes:

• A pickup in domestically generated inflation
• A contraction in the spreads between Bank Rate and the interest rates charged to many borrowers

Given the dour outlook for the economy and an on-going reblancing in the economy, I continue to assume that rate hikes in the UK are somewhere off in a very distant future. There are many parallels in approach between the Bank of England and the Federal Reserve with very compatible world views. King has proven quite adapt in conjuring reasons for maintaining loose monetary policy, and I continue to see strong evidence that he is reluctant to tighten for fear it could upset the rebalancing he eagerly anticipates. Indeed, King notes that there is no way to tell when the MPC may hike rates:

“Uncertainty inevitably surrounds both the speed of the rebalancing and the impact of today’s consumer price inflation on tomorrow’s domestically generated inflation. So it is simply impossible to know now at what point monetary tightening will begin.”

I am sure this reality frequently disappoints currency traders who keep pushing out target dates for the Bank of England’s first rate hike. In the meantime, there is every reason to bet against the pound when the opportunity arises. The biggest challenge is figuring out which currency to use in a bearish bet on the pound, not to mention when to make such bets. No real “safety currency” exists any more. The usual suspects have real issues:

• The U.S. dollar is on the verge of resuming the downtrend it was on prior to the financial crisis. Just read between the lines anytime Federal Reserve Chairman Ben Bernanke talks about the dollar.
• The Japanese have the support from the international community to weaken its currency, the yen. The renewal of strength in the yen is certainly unwelcome. The Japanese are also looking down the barrel of serious long-term issues given the aging population and tremendous debt burden (see in particular “Kyle Bass Reiterates the Case for A Sovereign Debt Default in Japan“)
• The Swiss franc has maintained the most consistent strength over the past two years (much to my surprise!) after the Swiss National Bank failed miserably to prevent the currency from appreciating against the euro. Sooner than later, the Swiss economy should buckle and compel market forces to reverse the currency’s powerful hold on traders.

If the eurozone ever resolves its sovereign debt problems, the euro might be the best play against the pound. Instead, shorting the euro versus the pound is actually the better trade given the euro’s sharp appreciation against the pound since 2008. (The volatility is also lower than the other options mentioned above).

I remain a huge fan of the Australian dollar, so this has become my favorite tool for shorting the pound. The “Aussie” cannot be considered a true safety currency because of the economy’s heavy dependence on commodities. Nonetheless, as long as I remain bullish on commodities over the long-term, I will stick by the Aussie. The pound is at historical lows against the Aussie with no end in sight:

The UK's rebalancing has tipped the scales strongly in favor of the Australian dollar

Be careful out there!

Full disclosure: short GBP/CHF, short EUR/GBP, long AUD/JPY, long AUD/USD, long USD/JPY, long FXA

(T2108 measures the percentage of stocks trading above their respective 40-day moving averages [DMAs]. To learn more about it, see my T2108 Resource Page.)

T2108 Status: 42% and Neutral.
General Trading Call: Hold. Identify some shorts to cover.

Commentary
Given that today was the stock market’s worst performance since August of last year, I should expect to get caught well off guard. Yet, this provides little consolation for extrapolating yesterday’s strong follow-through rally to an imminent return to overbought territory. Such are the perils of trying to read the tea leaves. The good news is that I noted the time was not to buy but to sell and prepare to short. My quote from yesterday is ringing VERY true today: “I am expecting fireworks for the summer from beginning to end.” We have started with MAJOR fireworks. (Also see my analysis of summer trading where I observe that the summer tends to end positively but produces very large losses when it ends negatively).

T2108 cratered back to 42% as the S&P 500 plunged 2.3%. The S&P 500 dropped right back toward the May lows, putting it right back into the thick of the former short-term downtrend. If the S&P 500 closes below the May lows, we should expect continued selling closer to oversold levels on T2108. So, I am reviving my downside target of the lower part of the 30-40% range for this cycle and aborting my previous assessment that we had re-entered an upward phase to over-bought territory.

S&P 500 plunges back into a bearish pattern

The dollar index did not soar as I would have expected. Instead, it was the Swiss franc that soared, recording all-time highs against the U.S. dollar, euro, and the pound. The Japanese yen was also strong, and the currency has regained its losses from yesterday’s downgrade warning from Fitch. It almost seems that on up days, we look to dollar weakness and down days we look to franc and yen strength. I am still developing and refining my understanding of who leads whom, but I think we can expect a lot more volatility in the stock market aided by jittery gyrations in foreign exchange.

Daily T2108 vs the S&P 500

Black line: T2108 (measured on the right); Red line: S&P 500 (for comparative purposes)

Related links:
The T2108 Resource Page
Expanded daily chart of T2108 versus the S&P 500
Expanded weekly chart of T2108

Be careful out there!

Full disclosure: long SSO puts, net long short Swiss franc, net long Japanese yen, net long U.S. dollar, net short British pound, net short the euro