Although far from a consensus view at the moment – just 11 of 39 analysts polled by Bloomberg expect the BoE to raise its quantitative easing (QE) target at its policy meeting this week – UK policymakers could well spring a surprise that takes sterling to fresh lows.
The arguments for further action from the Bank are certainly stacking up.
Activity data, most notably last week’s manufacturing purchasing managers’ survey, suggest the UK economy is contracting, while a similar disappointment in Britain’s services sector on Tuesday could compound the gloom.
With the minutes of last month’s BoE policy meeting already showing three of the nine-strong Monetary Policy Committee (MPC) members, including governor Mervyn King, voting to increase the UK asset purchase scheme by £25 billion to £400 billion, the odds are that the worrying activity data will prompt more members to back further monetary easing, or other measures to boost the economy.
Compounding the probability of further action has been the relatively weak take-up of the Funding for Lending Scheme (FLS), the joint initiative from the BoE and the UK government to boost bank lending and the British economy.
The latest data, released on Monday, showed that 11 UK banks borrowed £9.5 billion from the scheme in the fourth quarter of 2012, bringing the total drawn down to date to £13.8 billion.
That is just a fraction of the £70 billion available and hardly points to the FLS providing the boost to the economy that the UK authorities would have liked. Crucially, that points to weak UK loan data as being more a function of poor demand than restricted supply – something the Bank has not always believed.
| UK bank lending barely stabilizing |
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While that suggests the BoE is more likely to engage in further unconventional monetary policy measures – most likely an extension of its asset purchase plan but, possibly, as mooted by MPC member and deputy BoE governor Paul Tucker last week, a rate cut – the question is how sterling will react to the news.
Aided by the perception that the BoE is willing to see the currency fall and tolerate higher inflation in a bid to boost the economy, the pound has been a winner in the currency wars this year, with GBPUSD falling from above $1.62 at the start of January to stand at its lowest level in more than two and a half years, just above $1.50.
The rapid pace of the pound’s decline and the fact the market is now heavily positioned short of sterling have led some to believe the bad news is already priced into the currency. Indeed, despite a downgrade of the UK’s credit rating by Moody’s and last week’s poor manufacturing report, GBPUSD has found it hard to stay below the $1.50 level for long.
Part of that resilience has been blamed on the destabilizing effects of the Italian election result last week, which triggered a slide in EURGBP and prompted speculation of haven flows away from the eurozone and into the UK.
However, the supportive effect on sterling from the Italian elections appears to have been short lived.
“Despite the difficult political situation in Italy, investors are reacting with more calm compared to post-elections in Greece last year,” says Geoffrey Yu, FX strategist at UBS. “The European Central Bank has stronger tools for markets to contend with, and the economic outlook has improved for now, albeit from very low levels and expectations.”
Indeed, following the initial sell-off in EURGBP, UBS client data flow shows that last week saw the strongest buying of EURGBP since May 2010, with hedge funds using the setback of the Italian elections as a chance to enter new short positions in the pound against the euro.
Paul Meggyesi, FX strategist at JPMorgan, believes the adjustment in the pound to the UK’s dismal mix of low growth, high inflation, large twin deficits and super-easy monetary policy is not yet complete.
He says any decision by the BoE to restart its asset purchase scheme, let alone pursue one of the “blue sky” options, such as negative interest rates that some MPC members have been mulling in recent weeks, will further align sterling with the yen in the eyes of many investors. In other words, the pound, like the yen, will be seen as the intended victim of policy-induced devaluation.
“It could be argued that renewed QE could make gilts more attractive to foreign investors, in the sense that this places an effective cap on yields and may not, therefore, prove detrimental to sterling,” says Meggyesi.
“This argument is not without merit. Still, the evidence of the past few years is that relative central-bank balance-sheet trends have been an important drag on the pound.”
As Meggyesi points out, it cannot be a coincidence that, as the chart below shows, the BoE has done more QE than any other central bank in the world, has generated or at least presided over more inflation, and has simultaneously delivered the weakest exchange rate.
| Change in central bank balance sheet as percentage of GDP since January 2007 |
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As the evidence continues to suggest that the Bank’s policy initiatives are having little success in boosting growth, so the chances of further extraordinary measures from the central bank increase.
Indeed, it might be that policymakers view measures such as asset purchases and rate cuts as insufficient to stem the tide in the UK economy. That, in turn, could tempt UK officials to look to its currency as a policy tool.
Of course, that goes against the G20 mantra over currency policy, but as Japan’s recent experience shows, the likelihood of any concerted international reaction is remote.
Those that believe sterling is nearing fair value after its recent fall should be wary about a new chapter opening in the global currency wars as UK officials talk the currency down.