Sterling soars as Bank of England signals tighter policy ahead
17/Feb/2014 • Currency Updates•
Last week’s Inflation Report out of the UK provided the biggest news of the week. The Bank of England failure to push back significantly against market expectations of an early-2015 rise in rates was interpreted by investors as a relatively hawkish sign. Therefore, sterling soared against every other major currency, rising nearly 1.5% against the euro and slightly better than that against the US dollar. Aside from FX, financial markets saw a continuation of the previous weeks trends, as risk assets and emerging market currencies continued a cautious partial recovery of their January losses.
The Bank of England Inflation Report was the main news last week, and investors were not disappointed. The MPC signaled that tightening may come some time in early-to-mid 2015, more or less in line with market expectations. However, the lack of more explicit forward guidance on rates suggested that it is open to an earlier rise if the data warrants. The mere fact that this possibility is left open was seen by FX markets as a hawkish turn and sent sterling higher by between 1.2% and 2.5% against every other G10 currency. Also of note, the MPC indicated in the Report that the current stock of Gilts owned by the Bank of England would be kept until rates start rising.
European growth in the final quarter of 2013 came out at a slightly higher than expected 1.1% annualized rate. Performance in the periphery was mixed. While Spain and Portugal grew slightly above the average, Italy disappointed. Italian growth came out at barely 0.5%, unsurprising given that the Italian job markets has yet to stabilized. Greece dropped another 5%, in spite of the improvement seen in the PMI indicators there. We note that we are seeing some signs of a decoupling between actual growth and the various business indicators, which have traditionally been the most reliable forward indicators of growth in the Eurozone – a development that bears watching. Beyond economic numbers, ECB governor Coeuré signalled that the ECB is indeed watching the low inflation numbers, and that a negative deposit rate is a serious consideration if inflation numbers fall further. We think that markets are paying insufficient attention to these developments, and that the ECB is indeed one negative inflation surprise away from taking further action and easing monetary policy.
The streak of disappointing macroeconomic news in the US continued last week with soft reports from retail sales and industrial production, which fell 0.4% and 0.3% mom respectively. However, it is very hard to disentangle the effect of much-worse than typical winter weather across much of the Eastern US. Unfortunately, February has seen a continuation of winter snow storms, and therefore data out during the month of March may not be sufficient to answer that question. We continue to expect a slight acceleration to 3% trend growth in 2014, but that estimate is more uncertain than usual, particularly where the first-quarter numbers are concerned. We do expect the Federal Reserve to continue to look past any short-term softness in the numbers for now, as the uncertainty over the weather effect will not have dissipated by the time of their next meeting in March, where we expect another 10 billion reduction in the pace of QE will be announced.