BoE Preview – Rate Cut AND QE?

BoE rate cut eur/gbp euro forex blog GBPJPY gbpusd Kathy Lien US Dollar

Tomorrow’s Bank of England meeting is one of the most important events this month.  Back in July, U.K. policymakers made their plans to ease in August abundantly clear and now that the time has come, sterling has been surprisingly stable.  By giving investors sufficient warning, the market had the opportunity to completely discount a 25bp rate cut and the question now is if the BoE will do more. They could cut interest rates by 50bp or they could combine a quarter point cut with renewed bond buying. Quantitative Easing was a critical part of the BoE’s monetary policy during the financial crisis but with interest rates already so low, the effectiveness of QE is in question. Many economists believe they will revive the program but not this week. Since Britain decided to leave the European Union, the Bank of England has taken major steps to stabilize the financial markets and encourage lending – and so far it has worked!  Stocks are stable, yields have increased and the doomsday sentiment in the market is fading. A lot of this has to do with the U.K. government’s decision to postpone invoking Article 50 for the next year or two, reducing the immediate risk for businesses.   This means the central bank can wait to ease again when there is a greater evidence of a deep contraction in the economy.

Taking a look at the table above, there’s certainly been more deterioration than improvement in the U.K. economy since the July monetary policy meeting. However wages are up, the unemployment rate is down and consumer prices are ticking higher.  Second quarter GDP growth was also better than expected.  Although manufacturing, services and the composite PMI indices fell sharply in July, this morning’s numbers were not revised lower after the flash release.  When the Bank of England releases their Quarterly Inflation Report tomorrow, their forecasts will be grim – policymakers previously warned of a possible recession post Brexit.  Governor Mark Carney won’t have anything positive to say outside of acknowledging financial market stabilization.  Yet economic and financial conditions are not desperate enough for the Bank of England to rekindle their QE program.

In other words, we feel that the Bank of England doesn’t need to send a strong message to the market right now outside of a 25bp rate cut and a stern warning of more easing in the coming months.  If we are right, we could see a bigger short squeeze in GBP/USD that will allow investors to reset their short positions at higher levels.  The U.K. is not out of the woods, as growth will only slow further in the coming months / years because the U.K. government is simply delaying the inevitable.  If they cut by 50bp or restart their bond buying program, sterling will fall quickly and aggressively.

Euro: How Much Further Can it Fall?

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If you have watched the interviews that I recently posted, you will know I have been bearish euros for sometime. However now that the single currency has hit a 1 year low and is closing in on the psychologically important 1.30 level, you may be wondering how much further can it fall. Unfortunately I believe that the 1.30 level is more of a psychologically important level than a technical one. The currency pair should break it easily and fall to its “real” support level of 1.2960 (see chart below). Until the Germans officially vote in favor of the bailout package for Greece, the euro will have a tough time rallying.

If the EU/IMF announcement this weekend was aimed at supporting the euro, it has failed miserably. The euro has continued to weaken because of the abundance of unanswered questions. Here are just a few of those questions:

– Will Parliamentary Approval be Achieved?
– What will be the final package size?
– How quickly will aid come?
– How painful will the austerity package be for Greece?
– How much social strife will it cause?
– Will market turn on Spain, Portugal, Ireland and Italy?
– Will the ECB Completely Change the Rulebook because of Greece?

The concern ranges from how long it will take before Greece will receive funds to the possibility of contagion. Even though Eurozone finance ministers have approved a EUR110 billion bailout package, there still needs to be Parliamentary approval from individual nations that will affect the speed and size of the final bailout. Eventually Germany will come through because underneath all of the political backtracking, the government knows that in order to avoid a more damaging and embarrassing bailout of German banks, they need to bailout Greece first. There will be strikes and protests, but at the end of the day, the aid is needed to stabilize the region’s economy, support investor sentiment and prevent the euro from falling further. There is even talk that the Germans could be fast tracking their vote. However even if Greece is successfully bailed out, investors could quickly turn on countries like Spain, Portugal, Italy and Ireland especially if there are additional downgrades by rating agencies. This morning, there are rumors floating around that Spain could ask for an E280 billion bailout. As a result of these developments, the European Central Bank has amended their collateral rules for the second time because of Greece.

With fiscal stability still not achieved, there is a good chance that ECB President Trichet will remain dovish when he delivers his post ECB meeting press conference on Thursday, which is part of the reason why the euro has sold off today.

Finally everyone is watching Greek bond spreads. Here is a chart that I created on Bloomberg which shows the relationship between the EUR/USD and the 10 year yield premium that investors demand for holding Greek bonds over German bunds. As you can see, the yield has hit approximately 600bp and poised to blow out even further. Given its close relationship with the euro, I expect that to minimally mean a break of the 1.30 level.