Carney Wants Low Rates, Will Inflation Let Him?

Yesterday’s Inflation Report provided some good volatility in GBP markets, most of it taking sterling higher, as markets decided to bet on an interest rate rise sooner rather than later despite Dr Carney’s protestations.

Interest rates here in the UK will be tied to the performance of the UK’s jobs market. This is almost a duplicate of what the Federal Reserve in the United States has been doing.

Therefore, all things being equal, the Bank’s base rates should remain at current levels – 0.5% – or slightly below, until unemployment comes back towards a level of 7.0%. The current level of unemployment in the UK is 7.8%. The market, the Bank itself, most independent forecasters and economists and the Office of Budgetary Responsibility believe that the improvement needed in the jobs market will occur at some point in the mid-part of 2016.

Although we doubt a rate cut from the Bank of England is forthcoming, they have kept the door open to further asset purchases – or quantitative easing as it is commonly known – given the emphasis that Carney has placed on the fact that market interest rates imply a faster withdrawal of stimulus than is likely.

Market interest rates in the aftermath of Carney’s announcement are not listening, however. After an initial dip for sterling across the board and a rally for shares on the FTSE 100, the direction swiftly reversed as markets started to bet that instead, the Bank will raise rates sooner rather than later.

Carney made sure to emphasise that there were certain caveats to this forward guidance; occurrences which may not see rates rise, but certainly see a pause to the Bank’s plan of forward guidance. These caveats or ‘knockouts’ that would make them change direction are; if inflation looks to be above 2.5% on an 18- month to 2 year timeframe, if longer-term inflation expectations start to become unpredictable or if the financial stability of the UK economy is threatened.

The market is, in essence, betting that the Governor will have to break his low-rates promise due to the level of inflation before the unemployment level hits 7%, hence the sterling rise. Infuriating is one word for it. We are still keeping our bearish GBP call on, however, as although the recent run higher in economic data from the UK economy makes the recovery maybe slightly more dependable, dependable does not mean guaranteed. As soon as the data from the UK starts to slow its rate of gain through the rest of Q3, we could see a dramatic reversal in circumstances.

Away from London, Chinese exports rose more than expected in July boosting Asian equities and the Australian dollar higher. The run higher in AUD comes despite the fact that the Australian economy lost 10,200 jobs in July versus an expected gain of 5,000. Unemployment remained at 5.7% as the participation rate fell to 65.1% from 65.3%, reflecting people leaving the jobs market after being unable to find employment.

The euro has continued its recent strength this morning following stronger than expected German industrial production, although, much like Tuesday’s factory orders number, a lot may be to do with one-off ticket items from the recent Paris air show. The decision to hold Germany’s credit rating at AAA by Fitch with an attached stable outlook also helped euro remain strong.

Thoughts around Federal Reserve tapering will return today with the publication of the latest round of US job claims numbers. Claims are expected to come in at around 335,000 following last week’s better than expected 326,000. Recent comments from Fed members have been more towards a September taper than previously – the dollar is doing well against EM currencies as a result but versus GBP, EUR and JPY is still on the back foot. Today’s release could change that.