17th June 2014

GBP: Carney’s comments prompt a rally

In its May Inflation Report, the Bank of England re-anchored the market’s expectation for the first UK rate hike to Q2 2015. It did this by suggesting that based upon this rate profile, inflation would be at 2% in 2 years (the raison d’être of the Bank). So it is perhaps no surprise that Carney suggestion that “[the first rate hike] could happen sooner than the market expects” was a prominent headline last Friday. 

The FX market took its lead from the hawkish news, propelling EURGBP through 0.80. GBPUSD too took a leg higher on the news, though has failed to break through the key psychological level of 1.70. We think this response over looked three factors:

•    Mark Carney (Governor of the Bank of England) needs to convince 4 other members of the Monetary Policy Committee (MPC) to affect the pace of interest rates. During the Inflation Report press conference we were puzzled by Carney’s comment that the report was not validating any particular rate profile, because that seems to be exactly what it did. We think the contradiction may be because the Inflation Report reflects the consensus within the monetary policy committee, while in the press conference Carney is freer to express his own, more hawkish view. We think Carney has a lot of work to do to convince four others on the MPC of his view point, especially as he needs to convince them about intangible measures (such as the size of the output gap).

•    The remainder of the eleven page speech was more balanced. Apart from his hawkish view on the start date of the hiking cycle, Carney also made a number of more dovish comments. These were not picked up in the press. For example, Carney devoted a significant chunk of his speech to discussing why the Bank needs to be cautious when it tweaks rates. The UK’s private non-financial sector debt is high at 163% of GDP. Even more worrying for the Bank of England is that household debt is 140% of disposable income AND around two thirds of bank loans to individuals are at variable rates. This makes UK households very vulnerable to rising rates. The situation for businesses is little better with over 50% of loans at variable rates. Carney also re-iterated that this environment means that average policy rate is likely to be lower than in the past (we think this means 3% rather than 5%). In addition, Carney quelled expectations that rising UK’s housing prices would prompt an interest rate response. In the published text, his comments that the “Banks does not target asset price inflation” was underlined for extra emphasis.

•    10y US yields are at 2.61%. We continue to believe that US yields will rise over the course of the year. 

In our opinion, GBPUSD’s failure to break 1.70 last Friday despite 1) the market’s fixation on a hawkish comment from the governor of the Bank of England and 2) US 10yields trading in the low 2.60s makes us feel even more confident that GBPUSD will fail to extend much beyond 1.70 in the near term. Longer term, we maintain our view that GBPUSD will depreciate once US yields rise meaningfully. Whereas, we continue to like being long GBP against currencies where looser monetary policy cannot be ruled out – EUR (CHF) and JPY.

ZAR: Mixed news

There was mixed news for the ZAR last week. On the one hand, news wires reported that a wage deal between the Association of Mineworkers and Construction Union (AMCU) was imminent. If true, this could end a five month strike that has seen platinum production fall by 44% on the year to April (Bloomberg). On the other hand, Fitch downgraded its outlook on its BBB rating from stable to negative on Friday, citing South Africa’s deteriorating growth outlook. Market expectations that Standard and Poor would also take more negative stance were another weight on the currency. The overall impact was negative as the ZAR fell 1.63% on the week (Bloomberg).

Even with the possibility of a near term resolution to South Africa’s labour market issues, it could take months for platinum production to regain full capacity. As such we expect South Africa’s current account deficit to widen to north of 6% of GDP once more. We think this makes the ZAR particularly vulnerable to rising US yields. We maintain our bearish 1y forecast for USDZAR of 11.00.