BoE preview: Rate hike talk alive, exhaustion likely in GBP/USD above 1.34

The Bank of England [BoE] rate decision is due on Thursday at 11:00 GMT. The policy statement will be released along with the minutes showing interest rate vote split.

All 59 economists in a Bloomberg survey forecast rates to be kept on hold on Sept. 14. Markets will focus on any changes to the central bank’s voting pattern and change in language on interest rates.

Markets have priced-in the hawkish tilt

Cable rose above 1.32 yesterday after the UK August CPI surpassed expectations and rose at an annual rate of 2.90%. Sterling has gained 4% over the last three-weeks. The majority of the gains has been driven by the broad based USD sell-off.

Against the EUR, Sterling is down more than 8%. This not only hurts the UK exports, but is also inflationary since UK imports food products from the EU. So, the BoE would be more concerned about the drop in the GBP against the EUR.

Consequently, the central bank is likely to keep the rate hike talk alive and ensure the British Pound remains mildly bid around current levels (against EUR and USD). It appears that the markets have already priced-in the possibility of the hawkish shift.

• The Overnight Index Swaps market has already rushed to price in a greater probability of a rate hike from the BOE by year end.
• The market now expects a 30% chance of a hike in December, this compares with 20% a week ago.
• The probability of a rate hike has been brought forward to mid-2018, following higher-than-expected inflation numbers

Most investment banks say-

• September’s announcement could have “hawkish tinge”
• Expect a 7-2 split in favor of keeping rates on hold, but do not rule out a 6-3 vote split
• Further Gilt curve flattening is unlikely

The gilt yield curve could steepen sharply if the dissenting votes rise to 3. Moreover, it could boost the odds of November rate rise to coin toss levels.

Scenarios

Markets seem to have priced-in a slightly more hawkish tone, but the decline in Cable seen today on the back of mixed labor data suggest investors are not expecting a rise in dissenting votes to 3.

• Hawkish Scenario: 6-3 vote split... something markets aren't expecting. Thus, Cable would extend the rally to 1.35 levels.
• Dovish Scenario: BoE stresses the fact that wage growth remains anemic and the rise in inflation is mostly due to exchange rate. The vote split remains unchanged at 7-2. In this case, Cable could revisit sub-1.30 levels.
• Neutral Scenario: BoE acknowledges the spike in inflation, but votes 7-2 to keep rates unchanged. A spike to 1.34 is unlikely to last long.

Technicals - Weekly chart

Observations

• The falling trend line has been breached
• Confluence of rising channel and weekly 100-MA at 1.3395
• Stochastic and RSI indicates room for further gains, although on the daily time frame, both are turning lower from the overbought territory

View

• Spike to 1.34 is likely to be short lived, given the overbought nature of the daily RSI and Stochastics. Moreover, it would take a hawkish BoE to push the Pound above strong resistance at 1.34.
• Rejection at 1.34 followed by an end of the day close below 1.30 would signal the pair has topped out.

GBP/USD Options [Weeklies] - Investors buy cheap insurance against further upside

Source: CME

The options activity data published by the CME for GBP/USD Sep 15 expiry options show a big jump in the open positions in the Calls.

• 1.34 Call added 943 contracts on Tuesday and has the highest build up of open positions
• Total open open positions in Calls improved by 1948 contracts as opposed to 1200 in Puts.
• Clearly investors have positioned for a brief spike to 1.34 handle.

Risk Reversals at highest since mid 2014

The one-month 25-delta risk reversal currently stands at -0.213; the highest level since mid-2014. Despite being at 3-year high, the number is still negative, nevertheless, the improvement in the risk reversal indicates falling demand for downside protection, i.e. Put options.

US-UK 10-year bond yield spread - head and shoulders pattern

Daily chart

• The spread or the difference currently stands at 103 basis points. As noted earlier, there is consensus in the market that the UK gilt yield curve is likely to steepen [long duration yields rise]. Thus, the spread may break below the head and shoulders neckline.
• A break above 1.34 in GBP/USD, if accompanied by a drop in the US-UK 10-yr yield spread below the head and shoulders neckline, would signal continuation of the rally to 1.36 levels.