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Short Sterling underwhelmed by rate cut

06 February 2009

The Technical Trader’s view:

WEEKY CHART: The long-term chart, once the recent highs were smashed through, has been in a powerful, unhesitating, bull move. No sign yet of a slackening … but look closer.

DAILY CHART: Are these the seeds of a reversal? Note the small Head and Shoulders top that has been completed. See the minimum target for a bear move…down to 97.80. Deep into the band of support between 97.9250-97.74. But do we first need the added impetus and confirmation of a break down through the horizontal at 98.1550? And anyway, does this mean a reversal of the big weekly trend?

The Macro Trader’s view:

As expected the Bank of England monetary policy committee (MPC) cut interest rates today by 50bp taking interest rates to another all time low of 1.0%. The press release explained the cut as a necessary reaction to an expected undershoot of the 2.0% CPI target later this year, brought about by yet weaker economic conditions both locally and internationally, which includes continued restricted availability of credit, rising unemployment and reduced investment by corporations.

So why did Short Sterling sell off?

It is safe to say that no one yet sees a bottom to this downturn, either in the housing market or the wider economy.
Moreover, until Banks begin lending again more freely both to each other and the real economy, the contraction is likely to deepen as restricted credit availability causes a negative loop feedback that makes previously solid-looking assets become non-performing and further weakens the affected Bank’s balance sheet forcing it to further restrict its lending.

So the weak response in the Short Sterling market has nothing to do with traders perceiving an economic recovery is imminent.

The most likely reason is that with interest rates so low, there is very little room left for policy-makers to ease further, and with Libor spreads still elevated, the futures market implied cash rates continue to trade above the implied level of official interest rates. And that spread is flexible. So flexible in fact that, with so many stimuli hitting the economy (monetary policy, fiscal policy the weak exchange rate) traders is refocusing as to where the next big change in policy is likely to lie. Clearly with interest rates at 1.0% there isn’t much left on the downside, and traders think that when the recovery does come, policy will likely move swiftly back towards a more neutral level. That is a likely explanation for today’s market reaction, but are traders premature?

This is a more interesting question moving forward. The Bank is likely to ease further, albeit with only limited room left to maneuver, but this isn’t all they can do. The MPC was recently given new powers to buy debt instruments from the market, effectively by passing the Banking sector and pumping money directly into the economy. This is one type of quantum easing; another would involve the Bank of England directly purchasing Gilts as the Government issues them, and while not currently on the agenda, it may soon be.

In such an environment the MPC will not then be hurrying to increase interest rates. They are likely to remain at low levels for an extended period until it is clear recovery is well underway. So today’s negative reaction may be more likely to be driven by market fatigue as traders assume the MPC might become more ponderous with its policy actions. Only time will tell, but we think official interest rates may fall further as the economy continues to deteriorate, meaning any attempt for now to price in higher UK interest rates may be extremely premature.

Mark Sturdy, John Lewis
Seven Days Ahead

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