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GBP/USD: Trading the Bank of England Interest Rate Decision

Wed, Mar 4 2009, 06:09 GMT
by Daily FX Research Team

DailyFX

The Bank of England is expected to lower the benchmark interest rate by another 50bp to 0.50%, which would be the lowest level since the central bank was established in 1694, and as market participants project the MPC to conclude its easing cycle this month, long-term expectations for higher borrowing costs could boost the appeal of the British Pound going forward.

Trading the News: Bank of England Rate Decision

What’s Expected

Time of release: 03/05/2009 12:00 GMT, 07:00 EST

Primary Pair Impact : GBPUSD

Expected: 0.50%

Previous: 1.00%

Impact the Bank of England Rate Decision has had on GBPUSD over the last 2 quarters

February 2009 Bank of England Rate Decision

BoE Governor Mervyn King and Co. lowered the key interest rate by 50bp to 1.00%, which is the lowest level since the central bank was founded in 1694, to overcome David Blanchflower’s plea for a 100bp rate. Meanwhile, the central bank stated that the MPC ‘would need to use alternative policy measures’ to stimulate the economy as the interest rate falls close to zero, and is likely to adopt quantitative easing over the near-term in order to manage monetary policy going forward. As the outlook for growth and inflation deteriorate, the BoE is expected to take unprecedented measures to shore up the economy however, as Mr. Blanchflower expects the economic downturn to worsen ‘significantly’ during the year, the comments certainly underscore the dire state of the economy, and conditions are likely to get worse as turmoil in the banking sector intensifies. 

January 2009 Bank of England Rate Decision

The Bank of England voted 8-1 to cut the benchmark interest rate by 50bp to 1.50%, which is the lowest level since the central bank was established in 1694. The minutes of the policy meeting showed that the central bank dove David Blanchflower went against the majority as he pushed for a 100bp cut, but the MPC opted for a half-point reduction in order to avoid shocks ‘in both financial markets and the real economy.’ Despite the extraordinary efforts taken on by the central bank and Prime Minister Gordon Brown, the growth outlook for the U.K. remains bleak as fundamentals deteriorate at a record pace, and conditions are likely to only get worse as Europe’s second largest economy heads into its worst recession in over a decade.
Nevertheless, the BoE noted that the outlook for inflation ‘remained to the downside’ as economic activity falters, and may continue to ease policy further in order to maintain their 2% target for price growth.

What To Look For Before The Release

Traders with access to market depth information via the FXCM Active Trader Platform may use it to gauge the potency of the economic data release as well as to shed some light on the market’s directional bias. Increasing volume ahead of the announcement will telegraph likely follow-through behind whatever move is to materialize, while an imbalance in available liquidity on the Bid versus the Offer side of the market will tell us the direction major institutions are likely favoring ahead of the announcement:

Bullish Scenario:

If we see substantially deeper available liquidity on the Bid side of the market, this tells us that major price providers in the market are looking to buy the GBP against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bullish bias on GBPUSD ahead of the data release. 

Bearish Scenario:

If we see substantially deeper available liquidity on the Offer side of the market, this tells us that major price providers in the market are looking to sell the GBP against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bearish bias on GBPUSD ahead of the data release. 

How To Trade This Event Risk

The Bank of England is expected to lower the benchmark interest rate by another 50bp to 0.50%, which would be the lowest level since the central bank was established in 1694, and as market participants project the MPC to conclude its easing cycle this month, long-term expectations for higher borrowing costs could boost the appeal of the British Pound going forward. A Bloomberg News survey shows that 51 of the 60 economists polled expect the MPC to cut the key rate to 0.50% in an effort to stimulate the ailing economy however, as BoE dove David Blanchflower expects the economic downturn to worsen ‘significantly’ throughout the year, the odds for a marked recovery remains highly unlikely. The preliminary GDP report for the U.K. showed that the region posted it biggest economic contraction since 1980 as the annual rate of grow slipped to -1.9% from an advanced reading of -1.8%, and conditions are likely to get worse in the months ahead as households continue to face a weakening labor market paired with increased turmoil in the banking sector. Jobless claims in the U.K. rose to a 10-year high of 1.23M in January as 73.8K additional workers filed for unemployment benefits during the month, which raised the annualized figure to 3.8% from 3.6% in December.
Meanwhile, a separate report by the International Labor Organization showed that the annual rate of unemployment rose to 6.3% from 6.1% in November, which is the highest level since 1997, and as firms continue to face weakening demands from home and abroad, businesses are likely to slash their labor force in order to reduce costs. As the outlook for growth and inflation falter, deteriorating fundamentals paired with increased turmoil in the banking sector is likely to weigh on the exchange rate throughout the first half of the year, and policy makers are expected to take unprecedented steps to steer the economy out of its worst economic slump since World War II. At the same time, as investors remain risk adverse, the British pound should continue to hold its bearish trend against the U.S. dollar over the near-term as the reserve currency continues to benefit from safe-haven flows.

At first glance, trading the given event risk favors a bearish outlook for the British pound as the BoE is expected to slash rates to a record low however, as market participants expect the MPC to conclude its easing cycle this month, long-term expectations for higher rates could push the exchange rate higher. Therefore, if the central bank explicitly states that they will keep rates on hold going forward, we will look for a green, five-minute candle following the rate decision to generate a buy entry on two lots of GBPUSD. Once these conditions are met, we will set our initial stop at the nearby swing low (or reasonable distance), and this risk will determine our first target. Our second target will be based on discretion, and we will move the second lot to breakeven once the first trade reaches its target in order to preserve our profits.

On the other hand, fears of a deepening downturn paired with increased turmoil in the banking sector may lead policy makers to utilize all of their available tools and adopts a zero interest rate policy over the near-term in an effort to stimulate the ailing economy. As a result, if the BoE lowers the benchmark interest rate by more than 50bp and continues to hold a dour outlook for growth and inflation, we will look to sell the pound-dollar, and will follow the same strategy for a short trade as the long position mentioned above, just in reverse.

Published on  Wed, Mar 4 2009, 06:17 GMT