GBP: Time for the BoE to take charge - ING

While the Bank of England is widely expected to keep policy unchanged on Thursday, analysts at ING are looking for two signals that could mark a positive turning point in GBP sentiment and end the 'Great British Sell-off' in currency markets.

Key Quotes

“Signal 1: Market implied policy rate curve is too flat

• We believe that BoE officials may use the policy statement, accompanying minutes and vote split this week to try and shake up market expectations for the path of policy. Based on the UK OIS curve, implied market pricing suggests that there is a barely 1 in 4 chance of a 25bp Bank rate increase this year, which rises to only a 65% probability by the end of 2018. Likewise, surveys of households and businesses suggest that few anticipate meaningful increases in interest rates anytime soon.
• While policymakers may be less concerned about the repricing of immediate rate hike expectations, what may be making some on the MPC nervous is the flattening bias over the 2-3 year part of the curve. This is indeed starting to look at odds with an economy where inflation is set to rise close to 3% and economic growth remains positive, if somewhat subdued.”

“Engineering a steeper UK rate curve

• The minutes of the August MPC meeting stated that if the economy followed a path similar to the one the BoE anticipated “then monetary policy could need to be tightened by a somewhat greater extent… than the path implied by the yield curve”. This sentiment has been repeated in several subsequent BoE speeches and is likely to remain within the accompanying text.
• However, while this message may provide a backstop to any further flattening of the UK rate curve, we suspect that any meaningful uplift in short-term rates is unlikely to be achieved unless there is a hawkish shift in the vote split.
• External members Ian McCafferty and Michael Saunders will likely again vote in favour of an immediate 25bp rate rise, but the key story will be whether BoE Chief Economist Andy Haldane finally follows through with his threat to vote for a hike. Back in June, he warned that “the balance point [between tightening ‘too early’ and ‘too late’]… has shifted. Certainly, I think such a tightening is likely to be needed well ahead of current market expectations.”
• With this week’s data flow set to show headline inflation jumping back to 2.8%, wage growth edging higher and employment growth remaining robust, there is the clear potential for a 6-3 MPC vote split – with a third dissenter joining the ranks.
• Such a vote could prompt a reappraisal of the potential path for UK interest rates, while also providing a knee-jerk boost to GBP. However, we feel that the economic uncertainty brought about by Brexit will likely lead the MPC to hold fire until there is much greater clarity in the UK's post-Brexit investment environment - which may not transpire until the turn of the year. Moreover, even if we do see last August’s emergency rate cut reversed at some point over the next six to twelve months, our message would be that it is unlikely to mark the start of a pronounced tightening cycle.”

“Signal 2: Weak GBP tilting policy trade-off in favour of stimulus withdrawal

The GBP trade-weighted index hovering above the 74 level - and close to historic lows - had entered a territory that may require greater attention from policymakers (the BoE's "danger zone"). While the trade-weighted index has rebounded sharply to above 75 over the past week, we acknowledge that were it to stay at these depressed levels, then in isolation, it will result in an upgrade to the BoE's inflation projections at the next forecast round in November.

We wouldn't be surprised to hear greater BoE noise over sterling weakness at this week's meeting, primarily in terms of what this means for inflation overshooting the 2% target and whether the growth-inflation policy trade-off has altered for some MPC members. The following subtle changes in the statement could signal that the balance of risks may be tilting towards an earlier than anticipated withdrawal of the post-Brexit emergency monetary stimulus:

• Recent GBP weakness may prolong the squeeze in households' real incomes story. Back in August, one of the MPC's key assumptions was that the peak effect of GBP-induced inflation may now be behind us and that real wages were likely to recover. However, the combination of renewed currency weakness and still subdued wage growth means that the squeeze in households' real incomes story may persist for longer than previously anticipated. Hence, some MPC members may see greater economic costs of ultra-loose monetary policy.
• Risks are that inflation picks up beyond 3% later this year. For some MPC officials, 3% inflation may be the implicit line in the sand where the growth-inflation trade-off starts to tilt in favour of an earlier than anticipated withdrawal of the current emergency stimulus policy backdrop. While there is clear evidence that domestically generated inflationary pressures remain soft, we could start to see references to GBP weakness and imported inflation having "second-round effects" (eg, risks of rising imported input costs feeding through to domestic prices more meaningfully).
• Pronounced GBP weakness may have adverse consequences for inflation expectations. While market-based inflation expectations are far from becoming "de-anchored", we do note that both the five- and ten-year inflation breakevens have been on an upward trend since early August. The tail risk at this week's meeting would be if some members start to cite upside risks to inflation expectations stemming from a weak currency.

Overall, we believe that such "weak pound" references in the context of BoE policy talk could draw a line under any significant GBP-selling pressures in the near-term.”