Bank of England to markets: "Hold your horses"

The minutes from the BOE meetings have become the most important way for the market to gauge the Bank’s sentiment and make predictions about its next move. After feeling pretty confident in recent weeks that Mark Carney and co. had shifted to a more hawkish policy stance, the market rushed to price in two rate hikes by the end of Q1 2015, the latest minutes have left the market scratching its head once more. How can Mark Carney tell the market that it is too complacent about rate hikes in June, but then tell them they are pricing in too many rate hikes in July?

Back to the unreliable boyfriend theory:

Mark Carney is not to be trusted. If you place your heart (or your trade) with a capricious central banker then you should expect it to get broken. In fairness, Carney isn’t the only heart-breaker in town; Janet Yellen is also starting to change her message with alarming regularity leaving the market trailing in her wake. This is the new normal, so we had better get used to it.

Forward Guidance 2.0

While the BOE’s first foray into forward guidance a little under a year ago ended disastrously and nearly cost Carney his credibility, recent bank communications suggest that the BOE has shifted to a more subtle form of forward guidance. Carney doesn’t want the market to rest on its laurels, but equally, it doesn’t want the market to get too ahead of itself, as it invariably will try to do. Thus, over the next few months, as the bank gears up to its first rate hike, central banks will be working hard to calibrate their messages, which could include regular bouts of contradictory statements. If the market gets too focused on rate hikes then the BOE (alongside other central banks that are preparing to hike rates) will reign them back in. The rest of the year could be volatile.

The meat in the minutes:

• Overall, the tone of the minutes was more cautious then some had expected.

• Weakness in wage growth was a key concern. The Bank debated why wage growth was so weak in the face of strong employment growth; one explanation for this was an increase in the effective supply of labour that was willing to work for less money. The Bank is concerned that if this persists “it could bolster the pool of effective labour supply and restrain wage growth for longer than the Committee had assumed.”

• The Committee will consider the signal to take from the various indicators of the labour market in the August Inflation Report. Expect them to remain neutral until then.

• The Bank also considered various scenarios including if rates were hiked too early, which might leave the economy “vulnerable to shocks”. An alternative scenario was one rate hike in response to stronger economic data, which would facilitate a “more gradual path thereafter”.

• The minutes started by noting the rise in UK rate expectations and the pound in the prior month, which suggests it could be a cause of concern for some on the MPC.

• The Bank also sounded more cautious on the outlook for growth, with household spending slowing and the prospect of weaker growth in H2 2014.

The market reaction:

The initial reaction was a drop in UK bond yields, with 2-year Gilt yields (particularly sensitive to expectations for rate changes) falling to its lowest level since mid-June. This weighed on the pound, which is testing the key 1.7040 level, a prior level of resistance and key support zone. A break below here opens the way to 1.6960 – the 50-day sma.

In the short term the minutes are bearish for the outlook for the pound, and reinforce the recent high at 1.7192 as a medium-term top. Although we remain in a technical uptrend, after a year of gains the pound may be starting to look rich, especially if the BOE does not deliver rate hikes this year. Thus, we would expect a deeper pullback in the near term. If we break below 1.6950-60 – the 50-day sma and also uptrend support - then we could see a deeper sell off back to the late May/ early June lows of 1.6693.

Figure 1: The UK’s labour force participation rate has continued to trend higher.

Figure 2: Is this why wages have remained stubbornly low? Some at the Bank of England think so.