Bank of England forecast gloom takes shine off sterling

The latest Inflation Report from the Bank of England made for some glum reading for sterling bulls, although the weakening in the pound helped to propel the FTSE 100 to its highest level since 26^th July. The pound is down nearly 1% across the board after the BOE cut its growth forecasts for the UK, and Governor Mark Carney said that the UK’s economic potential is now only 1.75% GDP growth per year. Overall, the penultimate Inflation Report of the year put to bed notions that the Bank may hike interest rates later this year, with the market mildly prodded by the BOE to accept the prospect of a rate hike by the end of 2018.

Although the markets have brought forward their expectations for a rate hike, this is not the big story from today’s Inflation Report. Instead, weak growth prospects, 2017 GDP has been revised down to 1.7% from 1.9%, have taken centre stage. Wage growth was also revised down, with the bank now expecting wages to contract this year by 0.5% on an inflation-adjusted basis. This is grim reading, in fact, even though the rate markets may be looking for an earlier than previously forecast rate hike, the FX market could be testing the BOE’s resolve to hike at all over the forecast period. Considering the BOE does not expect UK growth to rise above 2% for the entire forecast period, perhaps the FX market is right to test Carney and co’s resolve to hike at all in 2018…

Is Brexit really to blame?

The BOE blamed Brexit for a lot of the UK’s woes, including weak wage growth. While we believe that the Brexit vote, and the lack of progress on securing a transition deal, are indeed hindering the UK’s growth prospects, we don’t think that the Governor was quite correct when he also blamed weak wage growth on the Brexit vote. Weak wage growth has been a problem for many years in the UK and across the world, and is thus not directly linked to Brexit. Interesting to note, is that the BOE expects a sharp uptick in wages next year to 3%, even though this was revised down from 3.5%. This looks optimistic and doesn’t chime well with the rest of the report. We doubt that wages will bounce back that quickly, unless we start to see a major labour shortage in the UK in the coming months, which is a possibility. If that happens it would likely be detrimental to growth, so not even a spike in wages next year may be enough to trigger a rate rise any time soon.

Rates vs. FX

Although Carney and co. gently prodded the market into accepting a near term rate hike, the BOE has stuck to its message that rate increases will be slow and gradual, which limited market enthusiasm. As mentioned above, elements of the FX market seem to be doubting the BOE’s appetite to hike rates next year, even at this early stage.

Credit, no big deal for the BOE

The other point to note is Carney’s lack of concern about credit growth. While he has expressed concern about a credit-fuelled expansion before, this was not the case today. Instead he urged caution on overstating the uptick in consumer debt, and said it is not a key metric for the MPC. Although some in the market had been looking for tougher talk on rates to stem consumer credit, Carney has made clear today that even if consumer debt levels continue to rise it won’t lead to higher interest rates. Instead it is likely that the BOE will target the sub-sector of borrowers and lenders most at risk, rather than choking off lending entirely and rocking the economic boat a la 2008.

FTSE takes its cue from the Pound

The correlation between the FTSE 100 and the pound has returned to negative today, with the FTSE 100 up 1.3% so far and GBP/USD down 1.15%. The 2-week correlation between the FTSE 100 and GBP/USD is now -0.88, which is a very significant negative correlation, and suggests that we could see further FTSE 100 gains if the pound continues to fall.

This correlation is only relevant for the blue chip index, unsurprisingly, and the more domestically focussed FTSE 250 only has a negative correlation of -0.3 over the same time period. That hasn’t stopped the FTSE 250 from rising today, however, if you are trading stocks and the pound, the broader index is less reliable than the FTSE 100.

Is Carney to blame for the weak pound?

Overall, the market was willing to accept an earlier rate rise, but the glum outlook for growth and wages has weighed heavily on the pound. The last point to note is that part of the pound’s decline could be growing frustration with Mark Carney who, yet again, flip-flopped on his prior position. At the end of June he sounded hawkish and said that he wouldn’t tolerate above target inflation indefinitely, which triggered the move above 1.30 in GBP/USD. However, today, he sounded fairly unfazed by UK price pressures, blaming them entirely on the Brexit-inspired pound sell off. This dialling back of his hawkish rhetoric may lead some to question the credibility of his forward guidance, and when a Governor of a central bank loses credibility the currency usually takes a hit.