- We have removed sterling versus the euro from our list of high conviction currencies
- Following Governor Carney’s signal, markets have gone a long way in pricing in a 2014 rate hike
- Although EUR/GBP has more downside, we judge that much of the near term move is behind us
BoE Governor Carney’s smoking gun
BoE Governor Mark Carney signalled that UK interest rates could start to go up before long. In the Governor’s Mansion House speech he said that ‘there’s already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced. It could happen sooner than financial markets currently expect’. The shifting stance of the central bank reflects the strong acceleration in economic growth and sharper than expected fall in unemployment. There is also concern about the strong rebound of the housing market and related elevated levels of household indebtedness. Mr Carney does not want to repeat the mistakes of the past, and therefore wants to ensure that household sector imbalances do not rapidly expand. The BoE’s financial policy committee will be given further macro prudential powers to restrain the housing market and related credit growth, and it could put already existing macro prudential tools into action. However, ultimately higher interest rates are the most powerful weapon it has. Overall, the Governor’s remarks support our view that the BoE will be the first major central bank to raise interest rates. Indeed, we have changed our forecast for the first policy rate hike to November of this year from February of next year. However, we have kept our projection for the end of next year unchanged, at 2%. This reflects Mr Carney’s assertion that rates will go up only gradually. Financial markets reacted sharply to the speech, with sterling futures rates rising by 10-20bp along the curve. Indeed, a rate hike by the end of this year is now almost fully priced in. Furthermore, more than 100bp of rate hikes is priced in by the end of next year.
EUR/GBP fell sharply as markets built in 2014 rate hike
Sterling rallied strongly on the back of Mr Carney’s remarks and the subsequent factoring of rate hikes. As a result, our year-end forecast of 0.80 in EUR/GBP was breached. Short euro and long sterling has been one of our high conviction views (as communicated in our FX Monthly of 20 November 2013). Given the change in our BoE view and recent market moves, we have lowered our year-end forecast for EUR/GBP to 0.79 (from 0.80) and we have also adjusted the path of sterling appreciation. However, our year-end forecast for 2015 remains unchanged at 0.75, as we have also left our target for the BoE rate at the end of that year intact.
Removing sterling from high conviction list
Despite these adjustments in forecasts, we have decided to remove sterling from our list of high conviction currencies. This conviction had been expressed versus the euro as short EUR/GBP, on the view that economic growth and monetary policy differentials would widen. This scenario has played out convincingly and we close the call with a 5% total return. The reason we have decided to do so is that markets have now gone a long way in pricing in the scenario of the BoE being the first major central bank to raise rates. Even though it is likely that market interest rate expectations will be adjusted further upwards, most of this adjustment looks to have already taken place. Therefore, the upside in short-term interest rates and the sterling is relatively limited in the near term. Market positioning fully supports this view. Speculative net sterling long positions in the futures market are close to a five year high. It is likely that these positions will dampen sterling’s upside. In fact, they make sterling vulnerable and could lead to asymmetric reactions to events and data. For example, if news or data are somewhat less favourable, investors could take profit on their positions resulting in a substantial downward correction in sterling. On the other hand, upbeat data confirming the scenario but not exceeding expectations, may start to gain increasingly less traction on the currency. On balance, the risk-return trade off no longer favours sterling.