The BoE forward guidance language was not as strong as expected. Being long green short sterling contracts was a fairly consensus trade, as market participants anticipated an uber-dovish Carney. Several brokers expected a 6.5% unemployment trigger. As a result, the greens and blues (1 year rates 2y and 3y forward) sold off sharply as the unemployment trigger was set at 7%. This occurred even though the BoE’s own forecasts for unemployment does not drop below 7% until Q2 2016, whereas the market is pricing in a full hike as early as Q1 of 2015.
One possible explanation for this divergence may be the persistence and volatility of inflation in the UK. Despite high unemployment, CPI in the UK has never declined below 2% during the recovery, and has hit levels as high as 5.2%. In fact, the BoE’s staff forecast for 2014 inflation hit 2.68% as recently as this February. As a result, the inflation ‘knockout’ of 2.5% is likely seen by market participants as being fairly vulnerable.
Nevertheless, with today’s move in yields, 5y UK swap rates are now roughly unchanged vs early July levels, when the BoE statement noted that “the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.” Absent a reversal, this suggests continued or additional dovish language from the MPC next month. With QE likely off the table for now, the MPC could note that the unemployment trigger could be moved lower, or they may adjust the inflation forecast language. IMO, the ‘knockout’ language is inappropriate, especially for forecasts. I.e., if the MPC’s inflation 18-24 months out is forecast to be 2.6% while the unemployment remains elevated, does it really make sense to “knock out” the guidance? Note that the MPC’s inflation forecast is also not published, so the market doesn’t have much clarity on that, even though that may be the knock out that is closest to being triggered.
Note also that the BoE guidance impacts market participants’’ assessment of ECB policy. Since the UK is an open economy with tight links to the EU, BoE policy changes have historically lead or been coincident with ECB policy changes:
- BoE Forward Guidance: Does not expect to hike unless at least one of 3 ‘knockouts’ are triggered:
- LFS measure of Unemployment falls to 7%
- The MPC’s forecast of CPI Inflation 18-24 months ahead >= 2.5%
- Medium term inflation expectations no longer well anchored
- the Financial Policy Committee (FPC) judges that the stance of monetary policy poses a significant threat to financial stability
BoE forecasts from the Inflation Report:
- the MPC’s judgment is that the path of market interest rates implies a faster withdrawal of monetary stimulus than appears likely given the current economic outlook.
- I think our biggest concern is, at this stage, and that over which we have the most influence, our biggest concern is the possibility that as the recovery gathers pace that there is an unwarranted change in expectations about the pace of the withdrawal of monetary policy stimulus.
- I would re-emphasize that we’ve significantly marked up our central tendency for the U.K. economy, both in terms of growth, with this forecast.
- the short answer is, no, we’re not at escape velocity right now.
Nikkei was down 4% ahead of the BoJ
The Japanese government aims to reduce the deficit in the nation’s general account from 23 trillion yen in fiscal 2013 to 15 trillion yen over the next two years, and cap the annual issuance of new government bonds at 43 trillion yen – Nikkei
- Wed: Japan Current Acct, Australia Employment,
- Thu: BoJ, Japan Eco Watchers Survey, US Jobless Claims, JapanMoney Supply, China CPI
- Fri: China IP, Retail Sales, Canada Employment
- Mon: Japan 2Q GDP, US WASDE reports, US RICS House Price Balance, Japan Machine Orders, Australia NAB Business Confidence
- Tue: UK Inflation, German Zew, US Retail Sales, Australia Consumer Confidence