The first Quarterly Inflation Report of the year triggered a near 150 pip jump in GBPUSD even though the BOE Governor Mark Carney admitted that there was a chance that UK prices could fall into negative territory in the coming months. However, Carney did not seem particularly concerned about the drop in prices, instead focusing on the upside risks to growth.
After calling this report “relatively straightforward” he went on to say: “The headlines today mask stronger underlying dynamics which will determine UK output and inflation tomorrow.” Essentially the bank is happy with the trajectory of growth and, crucially for monetary policy, the long –term outlook for inflation. The bank revised up its growth forecast compared to the forecast included in the November report, and it also believes that inflation will come back to the 2% target rate within 2 years, and rising a little further after that.
Leaning on the ECB
The ECB may have done the heavy lifting on the policy front for the Bank of England. Mark Carney seemed fairly sanguine about the Eurozone, saying: “Recent ECB actions should provide much-needed support to activity in our largest trading partner.” He also didn’t sound concerned about the prospect of another flare up of the Greek crisis, saying that even a Greek “dirty exit” from the Eurozone would be manageable for the UK financial sector.
The prospect for policy
The Governor told the market that its view on monetary policy was pretty much spot on, with the first rate hike still expected next year and then a gradual pace of hikes thereafter. Carney ruled out more stimuli at this stage, but said that the Bank still has the tools to provide a monetary policy boost if needed.
Essentially, the Bank believes that the economy is on target to require a rate hike in 2016, and if you think the Bank will add more QE, then think again, the ECB has already done that for them. Ahead of this Inflation Report some people in the market thought deflation fears would be enough to trigger a dovish tone from Carney. We did not adhere to this view, which turned out to be correct. The Bank is willing to look through the temporary effects of deflation, which means that even if the UK sees negative prices in the coming months, this will not deter the BOE from paving the way for a rate hike in 2016.
The GBP effect
The pound rose to a 6-week high vs. the US dollar on the back of this report. Carney’s comments reinforced to us that the UK has the second best economic prospects in the G10 behind the US, which could drive inflows into the pound going forward. Now that another round of stimulus has been more of less ruled out by the BOE, GBPUSD may be able to stay safely above 1.50. Obviously there are political risks around the election to consider, however, for now we remain constructive on the pound.
Adding to the pound’s attractiveness is the rise in Gilt yields on the back of Carney’s speech. The 10-year yield jumped by more than 10 basis points earlier, which is a big move for Gilts, and it seems to be following US Treasury yields higher. Higher yields should be pound supportive in the medium-term, as you can see in the chart below.
From a technical perspective the break above 1.5274 – the prior high from 6th Jan – was a bullish development that opens the way to further upside. The extension of that rally on Thursday could trigger a move back to 1.5620 in the medium-term– the high from 31st December.