Pound Dives After Bank of England Signals Caution as It Raises Rates
Comment of the Day

May 05 2022

Commentary by Eoin Treacy

Pound Dives After Bank of England Signals Caution as It Raises Rates

This article from the Wall Street Journal may be of interest to subscribers. Here is a section:

Six MPC members voted for the rate rise to 1%, while three voted for a larger rise to 1.25%.

The central bank also said it has asked its staff to prepare a plan for selling some of the bonds it bought as part of its past stimulus programs. That plan is set to be outlined in August, but bond sales would start later.

However, the central bank indicated that it is likely to raise rates more slowly, if at all, in coming months, with the very high energy prices that have followed Russia's invasion of Ukraine set to squeeze household spending power and weaken economic growth.

In its statement, the BOE said further rises in its key rate "may still be appropriate" in coming months, but added that two of its policy makers didn't support that guidance and instead thought it likely the key rate would stay at 1%.

"There were risks on both sides of that judgement," the BOE said.

That greater caution is a contrast with the Fed, which Wednesday approved a rare half-percentage-point interest-rate increase to a target range between 0.75% and 1%. Fed Chairman Jerome Powell said at a news conference that officials broadly agreed that additional half-point increases could be warranted in June and July given current economic conditions.

Eoin Treacy's view

The Pound rebounded yesterday and reversed that advance today following the reluctance of Andrew Bailey to talk about continued interest rate hikes. The decision was a long way from unanimous, which highlights the difficulty of containing inflation without causing a recession.
Ahead of yesterday’s audio I read some data incorrectly. I was looking at the Pound chart as I began and I’m afraid I got addled. The Bank of England’s interest rate hike was today not yesterday. I’m very sorry for sowing additional confusion. The markets are difficult enough.

Nevertheless, the conclusion that countries will have a hard time raising rates stands. The surge in energy prices is obviously a challenge for every importer, but thrifting and substitution are potential solutions even if the response time is lengthy.

The burden of floating rate and interest only mortgages are a long-term liability which inflation makes acute. There is no easy solution to rising mortgage repayments. It both raises rents and acts as tax on consumption. That means it is at least as deleterious to growth as rising energy costs by siphoning money out of the economy. The reality is the Bank of England would need to tank the property market to get inflation under control. That’s why there is so much indecision on the committee.

Crude oil in Pounds has been consolidating above the all-time peaks for the last few months. It initially rallied today to break the short-term sequence of lower rally highs, but global deleveraging risk sapped demand in late trading. The break above £90 was not sustained and downside follow through tomorrow would confirm a failed upside break.
Gold in Pounds continues to firm in £1500 area but some additional consolidation may be required before significantly higher levels can be supported.

Here is the key quote from Andrew Bailey today. “I recognize the hardship this will cause people in the U.K., particularly those on lower incomes,” Bailey told reporters in London on Thursday. “The biggest driver is the real-income shock, which is coming from the change in the terms of trade, coming particularly from energy prices.”

With local elections today, the clear potential is the ruling Conservative party will lose influence as voters voice their anger at high inflation. The political solution to rising inflation is price controls. That helps to get inflation down in the short term. It also sows the seeds for much worse inflation when the system is abandoned later. When the central bank is inhibited from raising rates, it is preferable to introduce price controls than risk a deflationary spiral from a property crash. 

The FTSE-250 initially rallied on news of fewer interest rate hikes but quickly began to price in what that means for growth. The Index is now falling through the 1000-day MA again and a clear upward dynamic will be required to check potential for additional downside.

The Pound is accelerating lower and racing to test the lows near $1.20 against the Dollar. While some consolidation is likely in that area, the continued threat of measures that will inhibit free movement of capital are a medium-term headwind to recovery.

From a very long-term perspective The Pound ranged above $1.40 for 30 years and broke lower following the Brexit referendum. It is has been distributing below that level for six years. A meaningful change of circumstances will be required to check potential for a further extension of the downtrend.

This section from Hoisington’s Quarterly Review may be of interest:

Monetary restraint has resulted in recession in all but 10% of the cases since the Fed’s founding in 1913. Though rare in occurrence, achieving a soft landing or even a mild recession may be a hollow victory. In 1966, the Fed, under Chairman McChesney Martin caused a credit crunch to try to contain inflation resulting from the Vietnam war. But, under serious pressure from the Johnson administration, the Fed reversed course and avoided a recession in 1967. However, the war inflation surged further out of control. The Martin Fed did induce a recession as a result of a serious credit crunch in 1969. This recession was extremely mild but caused the failure of the largest issuer of commercial paper (Penn Central Railroad) which resulted in a major financial crisis in May 1970. This led the Fed, now under chairman Arthur Burns, to speed up easing of monetary conditions, including taking the extraordinary step of cutting the margin requirement on stocks. Then, after a severe auto industry strike, GM agreed to a highly inflationary wage settlement with the UAW. In the 1971 recovery, inflation showed little, if any, improvement and the rebound was extremely tepid. Facing a Presidential election in 1972, the Nixon administration simultaneously closed the gold window, engineered a massive devaluation of the dollar and instituted wage and price controls to hold inflation in check while the Burns Fed accelerated money growth at a time when money velocity was stable. Growth was fast in 1972 and inflation was contained but, when the wage and price controls were lifted in 1973, inflation surged rapidly, and the Burns Fed was forced to adopt far more restrictive conditions than has been seen in 1966 and 1969. In 1973-75 a very deep recession followed. The Vietnam War/Nixon inflation was not resolved until after three years of severe monetary restraint under the Volcker Fed and deep recessions in the early 1980s. As these historical cases indicate, failure to knock out inflation may achieve better short-run economic performance but a terrible longer-term loss.

Gilt yields reversed an earlier decline to finished unchanged on the day as it continues to pause below the psychological 2%.

I believe this is the first time I have ever seen Hoisington express a bearish view on bonds. That in itself is a landmark event.

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