Thursday, June 18, 2020

Is there room for the sterling to fall despite expectations for the BoE?

  • Dollar
  • Pound
  • Bank of England


Analysts’ Pick: Is there room for the sterling to fall despite expectations for the BoE?

  • While economists signal their expectations for an increase in asset purchases, there may still be room for the sterling to continue to gain against the dollar in the short-term.
  • Negative interest rates are highly unlikely with most of the recent economic data within the central bank’s illustrative scenario analysis in May
  • The BoE is still likely to skew its statement more dovish leaning to manage market expectations for an economic recovery
  • Downside risks for the global economy may skew the dollar higher in the short-term and put downward pressure on the GBP/USD currency pair

The Bank of England (BoE) should be expected to keep interest rates unchanged at today's monetary policy meeting, especially since economic data has mostly been within the central bank's expectations. Based on the BoE's illustrative scenario analysis during its monetary policy meeting in May, the central bank expects the country's GDP to fall to around 3% in Q1 2020 and to fall another 25% in Q2 QoQ. In comparison, the UK's GDP fell 2.0% in Q1's preliminary estimates, while April's GDP declined 20.4% MoM. While Q2's data is still not available, the second quarter's GDP looks more likely to be closer to 20% than 25%, since April's hit to output was dominantly from sectors that were affected by the lockdown (Accommodation and food services fell 88.1%; construction fell 40.1%). This is likely as a result of the easing of restrictions on since May 11th, which will help lift output slowly but incrementally from May to June.

While inflation fell below the BoE's expectations for the in May, it still remains within the BoE's projection for an inflation rate of below 1% in the months following its meeting in May, or 0.5% inflation projection for Q2 2020. The plunge in inflation rates were also an effect of a mixture of factors instead of solely demand, which would mean that the central bank is likely to be less influenced by inflation at the current meeting to decide on the need for easing interest rates. Inflation plunged in part to a sharp decline in prices for transport, more specifically a decline in fuels and lubricants used in transport equipment (-16.7% YoY in May and -12.2% YoY in April) thanks to the depressed oil prices in April and May. In addition, the central bank will likely note that inflation will remain depressed for an extended period and that the actual impact will be highly uncertain, as a result of a global economic slowdown which will affect import and export prices as currencies remain highly volatile.

A dip in transport largely contributed to low inflationary rates


Fuels and lubricants contributed the most to the drop in the overall transport segment


Unemployment should be closely looked at by central banks amid the Covid-19 pandemic as businesses cut on spending and lay off workers to boost short-term liquidity, to prevent a prolonged economic contraction. In the UK's case, fiscal spending to help prevent layoffs has supported unemployment figures from dipping too far since the government has taken on a significant chunk of the pressure on the labour market through its furlough scheme. Unemployment rate beat expectations as a result, coming in at 3.9% in for the three months ended in both March and April, remaining below the 4.6% projection by the BoE for Q1 2020. 3.9% for the three months ended in April also suggests that unemployment for Q2 2020 is likely to underpin the central bank's forecast for 9.0%.

As a result, it makes little sense for the central bank to cut its interest rates to negative at this point in contrast to May. More likely is for central bankers to appear unanimous on a decision to keep interest rates lower for an extended period of time. The central bank is also more likely to reserve a negative interest rates strategy for more extreme scenarios, for example if the pressure from Brexit and any unanticipated downside risks put an immense amount of pressure on the British economy.

Overnight Index Swaps signal that financial markets don’t expect any rate cuts from the BoE at today’s decision


The more likely scenario is for the central bank to focus on asset purchases to give its quantitative program more flexibility to continue up to at least its next meeting in August, and possibly the meeting after that in November at a reduced pace. At the central bank's current pace of purchases (13.5 billion pounds of bonds/gilts per week), the central bank will reach its limit of 645 billion pounds by the start of July. Expanding it by 100 billion allows it room to extend purchases up until early September at the current pace, and possibly longer if it eases its pace as the economy continues to recover later in the year. Consequently, the BoE will likely expand its asset purchases to maintain flexibility. This will however be within economists’ expectations, which would imply the downside potential for sterling resulting from an expansion is more likely to be slight.

The BoE is more likely to expand its asset purchase program in order to maintain its current pace until at least its next monetary policy meeting in August


As for the outlook of the GBP/USD currency pair, it is currently skewed more towards the downside. Today's decision on monetary policy should put some downward pressure on sterling despite the market's expectations for expansion to asset purchases since it is more likely for the central bank to be more dovish instead of hawkish. Beyond the decision, the dollar will likely still have some room to strengthen against other major currencies in the short-term as risks are likely skewed closer towards the downside for the global economy. In addition, with new clusters of Covid-19 infections surfacing, it is probably only a matter of time and testing before other countries who have eased lockdown restrictions to experience some spikes in Covid-19 infections. While the impact from this will likely be temporary and is unlikely to be as significant as the first wave of the pandemic, it still represents some downside risk for currencies without the perception of safe haven properties.

A number of countries and states in the US has reported spikes in Covid-19 cases


Hence, GBP/USD looks more likely to face downward pressure in the short-term, possibly towards 1.2499's level on the announcement of the BoE's decision. It may experience a slight rebound after however, due to possible easing in demand for the greenback. In the short-term beyond the decision, the currency pair may be able to continue on a downward trend as risk aversion rises, possibly towards 1.2450 or regress back towards the 200-day moving average. Risks to this will be in the form of Brexit, which still remains a major uncertainty as the deadline for the UK to request for an extension to the Brexit negotiations deadline at the end of the month nears. Other risks would be impactful news on a possible vaccine for the novel coronavirus.

Technical Analysis:


Sterling is still trading above the 200-day moving average and looks unlikely to break it in the short-term. This can be regarded as a broad uptrend from the start of June, which was likely more of an effect of the weakening dollar as risk aversion started to fade. Over a shorter time frame, the Stochastics indicator signals that the currency pair is trading close to oversold levels, implying that there may be room for a rebound. A rebound however is more likely to be slight, as RSI is still well above 30.  The BoE’s decision later today may spark a selloff which could potentially retest and break the support at 1.2499 to fall towards 1.2450’s level and help break the Stochastics oversold levels to push the currency higher for a slight rebound back closer towards 1.2499’s level.

Support: 1.2499 / 1.2450 / 1.2352

Resistance: 1.2590 / 1.2668 / 1.2788

GBP/USD Chart (H4)