Chronicle: Pacified book relying on the blind BoE: Mike Dolan

LONDON, Nov 2 (Reuters) – The only positive thing currently being talked about for sterling is that Britain’s political chaos has eased somewhat – but that’s where the optimism appears to end.

As markets await the Bank of England’s latest policy decision on Thursday, it’s hard to believe it’s only been six weeks since it raised interest rates by a modest half a percentage point to 2.25% – a day before one of the most botched government budgets of the modern era. the story was revealed.

The unfunded tax cut plan almost blew up the whole economy.

Since September 22, the pound sterling, UK government bonds, pension funds and the mortgage market, the incumbent Prime Minister and Finance Minister and the credibility of UK economic policy as a whole have all been shredded. . And economic policy is only gradually rebuilding before the BoE meets again.

And even though the Bank is meeting this week amid expectations of another 75 basis point rate hike to 3% – which would be its biggest rate hike in 33 years – the central bank won’t. has not yet received the details of a reworked and costed budget from the new Prime Minister. Rishi Sunak and Chancellor of the Exchequer Jeremy Hunt.

Amid reports that they still have to fill a budget hole of more than £40billion with tax hikes and spending cuts, the plan has been postponed until November 17 – leaving the BoE with little visibility on this. against what it sets its monetary policy or how to formulate its inflation and growth forecasts.

Many fear that the pendulum is swinging too far in the direction of austerity, deepening the recession and tying the BoE’s hands on its degree of tightening.

Billionaire financier and famous pound speculator George Soros this week warned against such overreaction.

“Sunak must be careful not to impose too much austerity, which could trigger a full-scale financial crisis in a country facing many headwinds, including a shortage of affordable housing and a looming pension crisis,” Soros wrote. .

Many investors fear that the BoE will have to take the blame. “We think the Bank of England will err on the side of doing too much rather than too little,” said PIMCO portfolio manager Peder Beck-Friis. “Tight fiscal policies could end up bringing inflation down faster than expected, which could already lead to the Bank of England taking a break early next year.”

How the pound manages the middle ground can be critical.

Yield spreads in sterling and real
British Pound and UK current account

“UNDER-DELIVERY”

To the BoE’s credit, it has played a bad hand with some success over the past month and half of the turmoil.

After intervening to stabilize gilts and faltering pension funds, and managing to limit those purchases in just two weeks, it went even further on Tuesday by actively selling gilts back into the market without much disruption – part of its balance sheet planned but delayed. .

Tuesday’s steady gilt selling could be a mark of bond markets’ rapid recovery since the September shock – allowing the pound to rebound almost 10% from the record low hit by the US dollar the week after the “mini” budget.

Alongside hopes for a more credible fiscal overhaul, the rally in both markets helped push expectations for a rate hike this week down 125 basis points at the height of the crisis. It also lowered the implied policy rate next year by some 150 basis points to 4.75% over the same period – below the US Federal Reserve’s assumed “terminal rate”.

All of this may cause investors to return to the pound in hopes of a long-term recovery from undervalued territory – or worry now that relative yields on interest rates will never compensate. fully the inherent risks.

Deutsche Bank currency strategist George Saravelos, who has warned that a classic sterling crisis could be brewing weeks before the fiscal blowout, believes the pound can only stabilize here at best, even if the worst of the fiscal policy credibility crisis was over.

Saravelos said any overshoot from the political shock should allow traditional positive yield-currency correlations to resume.

Moreover, Britain’s chronic current account deficit with the rest of the world – the Achilles’ heel of the pound – may well shrink further from the explosive energy shock levels earlier this year, so that household spending and imports are squeezed and that energy prices are capped amid all the fiscal tightening. .

But “these fiscal changes are likely to come at the expense of growth,” Saravelos concluded, adding that Britain’s inflation-adjusted real yields were still too low against other major currencies and that a further slide in the pound sterling at $1.08 was likely this year unless the BoE indicated it would. take rates up to at least 5%.

“We see BoE-biased risk looking dovish this week and ultimately ‘under-delivering’ relative to current prices,” the Deutsche analyst wrote. “As global growth slows and rates rise around the world, attracting capital becomes more difficult.”

The HSBC team is hopeless, offering only a crumb of reassurance that they didn’t expect to see the pound below dollar parity this year. For them, Britain’s “twin deficits” in the budget and balance of payments still require the economy, interest rates and the currency to continually adjust to find balance.

Long-term valuation models have been of only marginal help in judging where the pound will go from here, they said.

“In previous periods of sterling undervaluation after significant supply-side structural shocks to the UK economy – in 2008 and 2016 – the currency fell around 20% below its fair long-term value,” HSBC said. “With the pound currently undervalued by around 10%, a further 10% decline is plausible. But such an excessively low price is unlikely to hold.”

Rise in central bank rates and the pound sterling
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The opinions expressed here are those of the author, columnist for Reuters.

by Mike Dolan, Twitter: @ReutersMikeD; Editing by Josie Kao

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The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed to integrity, independence and non-partisanship by principles of trust.

Mike Dolan

Thomson Reuters

Mike Dolan is Reuters Editor-in-Chief for Finance & Markets and has worked as an editor, correspondent and columnist at Reuters for the past 26 years – specializing in the global economy, policy-making and financial markets of the G7 and emerging economies. Mike is currently based in London but has also worked in Washington DC and Sarajevo and has covered news events in dozens of cities around the world. A graduate in economics and politics from Trinity College Dublin, Mike previously worked with Bloomberg and Euromoney and received Reuters awards for his work during the financial crisis in 2007/2008 and in frontier markets in 2010. He was a regular columnist for Reuters in the International New York Times between 2010 and 2015 and currently writes two weekly columns for Reuters on macro markets and investing.

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