The BoE are in a tight spot, faced with some difficult choices, which will have significant consequences for the fundamentals of the UK economy. Their credibility is on the line. They face a tricky trade-off between growth and inflation. Policy tightening is necessary to keep inflation expectations anchored and preventing a wage price spiral, but tighten too much or too fast and the economy will end up in the A&E. Do they prioritize inflation which is evident and concrete or the more abstract potential of a what if recession? The UK consumer is being treated like one of Mike Tyson’s punching bags at the moment, taking hits from all angles as energy costs surge and tax hikes filter through. The cost of living squeeze is well and truly underway. Consumer confidence has been decimated as indicated by GfK’s metric hitting multi-year lows. This has consequently led to a tightening of purse strings with consumer spending (the heart of the British economy) being put on ice.
On a brighter note, the excess savings the UK consumer would have built up during the pandemic could help the UK economy battle through, however, a murky economic environment will likely suppress animal spirits and could limit the spending of said savings.
Let’s start with the policy basics. The markets are priced for around 30bps at Thursday’s meeting, signifying a small chance of the BoE moving by 50bps. I’d be surprised by this. I’m expecting a 25bps hike, taking the bank rate to 1%. Now the voting dynamics will be interesting. Most expect an 8-1 in favour of 25bps, but could we see more than 1 dissent for a hold or even maybe some dissents for 50bps? I’ll also be scanning the statement to examine whether the wording of further tightening “may” be required is kept the same or changed to “likely”.
With the bank rate reaching 1%, sales of gilts (quantitative tightening) will come back into the spotlight. I don’t think hitting the 1% threshold will automatically trigger immediate action. This is unchartered territory for the BoE and they won’t want to cause unnecessary market volatility. There are additional concerns about the liquidity within the gilts’ market. Don’t be disappointed if details are slim on the QT front. The BoE will likely enter into a consultation phase to decide the pace and date at which it would begin (likely end of Q3 or beginning of Q4).
We’ll also be receive a fresh set of economic forecasts. Inflation obviously will be receiving a punchy revision upwards (weaker currency, tight labour market and rising energy prices), whilst growth will be downgraded and unemployment could tick up slightly or remain flat given labour market dynamics.
It depends how negative the growth revisions are too for the impact on the unemployment rate. Another important metric to assess will be where the MPC pin their long run inflation forecast based on market rates (end of forecast horizon). If it falls back below 2%, then again it means the BoE believe the market are being too aggressive in their pricing. Currently the markets are priced for the bank rate to reach 2.5% by early spring next year. This seems highly unlikely amidst the UK economic backdrop and could pose a significant headwind for Sterling as the market prices these expectations out. Will the penny finally drop at this meeting? FX options markets are expecting movement that’s for sure with 1-week implied vols for GBPUSD and EURGBP are around the 80th percentile vs their 12-month range
- GBPUSD: Cable is desperately trying to hold the 1.25 level which will be key for this meeting. The RSI is trying to move out of deep oversold territory. I've put some Fibonacci levels on the chart to give an idea of where rallies could be shorted or key levels broken for a trend reversal. On the upside 1.268 has solid resistance going back to 2020. If 1.25 breaks the next major support is around 1.225 and then 1.20.
- EURGBP: One of my favourite trades technically. When the RSI touches the 63.68 level, the 200-day SMA and the upper trend line of the descending channel, shorts have been the order of the day. There are multiple target levels such as the 50-day SMA and the 0.83 major support. We will need to monitor if these conditions remain in the event of a sea change come Thursday.
- GBPAUD: Another FX pair I think you should have on your radar. With the shock hike and hawkish tones from the RBA we could see some divergence open up here. We've seen this cross run into some resistance at the 50-day SMA and roll over. The RSI is also following price directionally, but not at any key levels to provide informational value. For the bulls a move back into the 1.78 region around the 50-day SMA could be a potential target level, while on the downside, 1.75 will be key.