Bank of England Super Thursday: Three is the magic number for further GBP strength?

Tomorrow represents a landmark in BoE communication: the MPC decision, MPC minutes and August Inflation Report will be released simultaneously at 12 noon, with the IR press conference starting at 12.45. With a view to the deluge of information to process, I offer some views on what market participants should be paying watching out for, together with a few tentative predictions. Overall, I suspect that there is room for GBP to strengthen on the day, but not hugely unless we get a surprisingly hawkish MPC vote. The key points are:
• My modal case of a 7-2 vote equates to limited GBP upside, depending on what the minutes imply about July’s “number” of MPC members not voting for a rate rise.
• But a 6-3 vote would not surprise me and would be more GBP bullish, especially if Forbes rather than Miles dissents (both dissenting is conceivable and would be very GBP bullish).
• The modal inflation forecast will probably be little changed, but the downside skew will likely be eliminated as a step towards rate rises: the news will be in the skews.
• While MPC pragmatism on GBP strength will likely continue, there may be further material on the protracted impacts of GBP strength on inflation as a backstop to ward off excessive GBP strength.
• MPC will likely try and reinforce the message of rate rises being limited by including further details on the sensitivity of household debt (although more fixed rate mortgages reduces it).
• Data dependency will likely be a recurring theme, as per the Fed.

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MPC Vote: 6-3 possible, bigger impact if Forbes rather than Miles dissents

The most important component will likely be the actual MPC vote. And market appetite for a split vote has been whetted by Carney and Miles’ recent hawkish speeches and by the July MPC minutes revealing that for a “number of members” the decision was becoming more finely balanced (rather than the previous “two”) with regards to a small Bank Rate rise (and Greek-uncertainty caveats no longer seem relevant).

Most market commentators seem to be split between a continuation of the 9-0 and or 7-2 vote as the most likely occurrences. So a continuation of 9-0 voting would be a negative surprise for a portion of the market, likely leading to a GBP sell off and lower yields. The reverse would be expected in a 7-2 with Weale and McCafferty dissenting: this is my central case given their previously-stated views and the UK data flow. But the moves would likely be relatively contained in either scenario as little new information on MPC views would have been revealed in either case. That said, a 7-2 vote would mean the MPC minutes revealing the updated views of the other members who getting close to raising interest rates and how many of them there are (detailed analysis textual analysis would kick in).

But I suspect that the risks are skewed to greater rather than less dissention and hence GBP upside. A 6-3 vote would not surprise me and 5-4 is not completely out of the question. Why? Because the volte face of the former arch dove Miles suggests that a tipping point has been reached within the MPC: other members are likely to share his well-argued view. Specifically, previous MPC concerns about low inflation affecting pay settlements now look overblown relative to monetary policy at emergency settings appearing increasingly discordant with the UK’s solid macro fundamentals and the argument that raising sooner helps achieve the meta-goal of ensuring only mild eventual Bank Rate rises (given high debt levels).

An important concern is that an early rate rise vote risks adding further GBP upside, not helping the still-imbalanced recovery and adding to the external disinflationary headwind. But dissenters may well try and prevent higher rate expectations 1-2 years out, those most closely aligned to GBP movements, by re-stressing that this means that rates are eventually going to rise less than were rate hikes to be delayed. It remains to be seen whether market participants will buy that story, given the mixed history of forward guidance: rate rise expectations could plausibly rise back to the levels following Carney and Miles’ speeches. But more fundamentally, dissenters will likely believe that the inflationary pressures emanating from the labour market will continue to outweigh those external headwinds i.e. the economy “can handle” rate rises.

A 6-3 vote featuring David Miles as a dissenter would likely be more dovish than other 6-3 votes, given that this will be his final MPC vote (and we obviously don’t know Vlieghe’s views). Forbes looks like the next most likely to become a dissenter: in June she argued that “Inflation appears on track to rebound towards target by early 2016” i.e. earlier than implied by the May IR. Despite Miles’ imminent departure, both him and Forbes dissenting would nevertheless likely have bigger impact than a 6-3 vote not featuring Miles, at least initially, given the psychologically-important impact of a rate rise only being one vote away.

Any rate hike votes from an “internal” MPC member would likely be interpreted as particularly hawkish, although this appears pretty unlikely. That said, there are some hawkish elements within Shafik’s generally consensual views e.g. her May 22 Comments that there are “nascent signs that some of these headwinds have already begun to ease…the factors pulling down inflation will not do permanently”. And Broadbent’s opposition to the final July 2012 slice of QE suggests he may also have nascent hawkish tendencies, perhaps also evidenced by his March comments that “the likelihood of a broad and protracted deflation, afflicting wages as well as prices, is relatively low”. Unfortunately his lack of subsequent comments mean that we can’t tell how his view has evolved.

But the July minutes are clear that “a number” of members who see the decision as finely balanced is four or less, even without the impact of Greek uncertainties: “For most members, even before accounting for the recent increase in uncertainty in the external environment, the current stance of monetary policy remained appropriate.”

Inflation projection: news in the skews?

The May IR forecast inflation back at target 2 years out and slightly above target at the 3 year point. But there was a negative skew to inflation in first year and half of the forecast. The broad macro developments since May suggest that there will likely be little change to the central inflation projection.  The upside news from strengthening domestic activity and stronger than expected wages are, big picture, counterbalanced by sterling’s further 3% rise, higher market interest rates (although down a little from the Carney-driven peak in July) and lower oil price futures. And in any case the application of judgment may well mean that there is little change, should the majority of the MPC want to again validate recent market pricing of rate hike around April 2016 (aiming to counterbalance any impacts on rate hike expectations and sterling of a relatively hawkish vote).

But I previously discussed how the first step in the BoE moving to a rate hike would be for the negative inflation skew to be removed/reduced. And the continued AWE uptick can motivate a more balanced fan chart: the risk of low inflation feeding into pay (and back) seems to have receded.

Likely continued pragmatism on GBP but risk of shot closer to bows

MPC have thus far appeared relatively sanguine about sterling’s renewed strength. I anticipated  that a combination of arguments would drive such pragmatism in the near term, despite the REER having risen to relatively elevated levels. Carney did, however, fire a shot across the bows in his 16 July speech, albeit with the meat of the argument relegated to a footnote (“the current rate of core inflation is being dragged down by import prices by around 1 percentage point…reflects, in part, changes in the value of sterling…not only are the effects sizeable, they are potentially protracted”) . But given that another footnote stated “MPC expects to refine these its estimates of these effects in future Inflation Reports” I would not be surprised to see an Inflation Report “box” on this tomorrow.

Carney could then refer to this should he wish to push back a little against GBP strengthening with a relatively hawkish MPC vote (in addition to reiterating the mantra of rate rises being limited and gradual). But the aim would likely be to prevent GBP strength accelerating rather than actively trying to talk it down like the RBA and AUD (until Tuesday). Big picture MPC should view GBP strength as a corollary of the relative strength of the UK economy i.e. has a “fundamental” underpinning that are hard to fight even if MPC wanted to (Carney was clear about the benefits of a freely floating currency at the TSC).

Potential more detail on household sensitivity to rate rises

As mentioned above, Carney and Miles have both stressed the importance of keeping eventual interest rate rises small, given the nascent fragility engendered by UK household’s high debt to income ratio (which has fallen largely because of higher income rather than because significant debt has been paid off). That said, the increased prevalence of fixed rate mortgages acts a buffer: BoE data show that 82% of recent new mortgages have been on fixed rate deals (down from 90% a few quarters ago) taking the share of the stock to 44%. But on July 16th Carney focussed more on the exposure to floating interest rates, arguing that “Over a half of UK mortgagors would pay higher interest rates in a year’s time and close to three-quarters of mortgagors in two years time”. So the Inflation Report may feature more detail on such calculations and sensitivities: Carney concluded that there was more to learn as rate interest rates increase. This could also spell out the latest view on the exposure of the most indebted households: BoE Research last year indicated that such distributional effects were not serious from a macro persopective under the most plausible scenarios.

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But it seems likely that Carney will want to use the high-profile occasion to give households due warning to get their finances in order before MPC starts raising interest rates. When Carney introduced forward guidance he stressed that the aim was as much about communicating with households and firms as with financial markets (more so at times) which he may well repeat tomorrow. And this message helps him try and convince financial markets that gradual rate rises will be the quid pro quo to early rises.

But the uncertainty about the future path of interest rates, with nothing being baked in i.e. data dependency as per the Fed, will likely be a recurring theme tomorrow.

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