The sterling reaction to Carney

The new Bank of England governor is certainly causing waves, from the cameras on his first day, the bombshell statement (for markets) after his first meeting and now the volatility caused by his first inflation report. So why is sterling higher when markets were meant to have more certainty on rates staying low for longer? There are 3 principle reasons.

Firstly, it’s conditional. This sits in contrast to attempts by central banks (Bank of Canada and the Fed in 2009, the ECB last month) to link low rates to a certain period of time, even if couched in fuzzy terms such as “extended period”. This conditionality means the market has to attach a risk premium to the pledge, so factor in the possibility that rates are more likely to be higher should events turn out different. This has translated into higher market expectations of interest rates from 2015 onwards.

Secondly, there are a lot of get-out clauses, or knock-outs as the BoE prefers to call them, so specified conditions that would allow them to deviate from their commitment to keep rates low and retain the current level of asset purchases so long as the unemployment rate remains above 7.0%. So these relate to inflation expectations (somewhat subjective), the Bank’s own inflation projects (subjective from their side) and the financial policy committee’s judgement that the stance of monetary policy threatens financial stability (very subjective). Suddenly, there are a lot of judgements to be made on an going basis in deciding monetary policy and this increases the uncertainty going forward.

The third issue is that if rates are held lower for a longer period time than previously expected, the risk is that they move up faster beyond that period. You can see the impact of this assessment on money market futures, with implied rates on short sterling contracts lower to the end of next year, then higher from 2015 and beyond as the Bank is seen playing catch-up on raising interest rates. Of course this is a long-way out, given the uncertainties that prevail even from one month to the next on the economy, but its impact is also evident on the yield curve, with short-dated bond yields lower and yields 4 years and out having moved higher.

So for sterling, having sold off near 1 big figure on cable after the initial headlines, the currency finds itself well over 2 big figures the other way, so from near 1.5200 to 1.5460. There remain the usual caveats about thin liquidity in summer markets as part of the explanation for the price action. But the bottom line is that the Carney we have running the BoE is different from the perception of a dovish QE advocate he was initially painted as when he was appointed and markets are having a tough time catching up to the reality. Short-term, this sterling move could unwind, given the less aggressive moves seen in interest rate markets. Beyond that, the outlook is for greater volatility and a much greater interest in the monthly labour market data.

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