Sterling Unwinds Most of BOE-Inspired Gains, but Rates Market Does Not

Sterling peaked on September 20 near $1.3660.  It traded to
nearly $1.3220 today.  It has fallen
in nine of the past dozen sessions.   The main culprits are the
broader US dollar recovery, disappointing UK data, and perhaps some Brexit
anxiety, spurred by the continued hardline push by Johnson.  

With today’s loss, sterling had
practically returned to the lower end of the range seen on September 14 when
the minutes and comments around the MPC
meeting was considerably more hawkish than expected.
  While the
currency has corrected, interest rate expectations remain elevated.  The implied yield on the December short-sterling futures contract rose from about 38
bp at the start of the week that the BOE met to  56 bp on September 20,
when sterling peaked.  The implied yield currently is near 53

In fairness, sterling’s advance did not begin with the hawkish BOE, but
the latest leg up began in late August
when sterling was trading near $1.2775. 
The central bank’s hawkishness came late in the advance and market
only the final leg of it.  The decline over the better part of two weeks
has retraced 50% of the gains since
late August (found near $1.3215).  The 61.8% retracement is near

Adding to the negative technical tone is the five-day moving average falling
through the 20-day average for the first time since early September. 

Trend following and momentum models often using some combination of moving
averages and we use the five and 20 as a broad proxy for such participants,
even though they may use other moving averages, and in combination with other
indicators.  Looking at the other technical indicators, we see the Slow
Stochastics have turned down hard, while MACDs have crossed over more
recently.  That said, if sterling met the 50% retracement objective of the
rally from late-August, it could post some corrective gains.  The initial
target would be around $1.3350, which corresponds
to last week’s lows. 

According to Bloomberg’s interpolation from the OIS suggest the market is
pricing in around almost an 85% chance of a rate cut before the end of the
year, with November 2 favor
.  On
September 20, when sterling peaked, the odds, according to Bloomberg, stood
near 75%.  The  September manufacturing and construction PMI disappointed this week.  Tomorrow, the
services PMI will be reported.  If it too disappoints, the market may
begin to adjust its interest rate wager.  

Part of the challenge is that the economic cycle and the price
(inflation) cycle are not perfectly in sync
.  While the UK economy has
gradually slowed and continues to do so,
inflation has not peaked.  It still
seems reasonable that it does peak here in Q4 as last year’s sharp sterling
fall drops out the year-over-year comparisons.  

As we have noted, nearly every year, but 2016, since Carney took over the helm of the BOE, he has threatened that an rate increase may be needed, and if rates do go up they will be gradual, but more than the market may be expecting.  Last year, after the referendum, the BOE eased policy, by cutting interest rates, resuming its asset purchase and several other measures.   It is possible that the MPC judges that such accommodation is no longer needed.  It is, though awkward to take back the accommodation as household purchasing power is being sapped and the economy appears to be slowing.  The contraction in July service spending in the UK, reported last week is worrisome sign. 

Meanwhile, Brexit issues continue to percolate.  Johnson pushes
for a hardline and then capitulates to the Prime Minister’s position. 
Today, the European Parliament confirmed the impression from the EU
negotiators, which despite May’s recent
speech and the formal suggestion of a transition period, the talks are not
ready to proceed to the next phase.  Specifically, the European Parliament
voted 557 to 92 (29 abstentions) to postpone starting the new phase at the EU
Summit on October 19.  

Ironically, some in the UK government reportedly hoped that if the FDP
were part of the new German government, Brexit negotiations could go a bit
It does look like the FDP will be in the governing coalition,
and it might even get to have one of its members, perhaps the party leader,
replace Schaeuble as finance minister.  However, it is not clear, and
won’t be for some time, whether the FDP
changes the EU’s negotiating position.  

Speculative positioning in the futures market is skewed by the contract roll
(from September to December), but as of last Tuesday, the speculators were net
long sterling in the futures market for the first time in nearly two
At the end of August, speculators were net short 51.6k
sterling futures contracts.  As of a September 29, they were near long
nearly 5.1k contracts.  In the latest reporting week, speculators covered
11.6k previously sold contacts.  The gross short position fell by a third
to 75.1k contracts over the past two reporting period.  The speculative
gross long position rose from 60.1k at the end of August to 80.1k as of last
Tuesday.  It is the largest gross long position I three years.  The large short speculative sterling position
that may have discouraged new shorts earlier has been corrected.  


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