BoE: 50bp cut would be sterling negative - RBS

James Nelligan, Currency Strategy Analyst at RBS, suggests that a weak US dollar and a fully priced 25bps BoE rate cut meant it was hard for cable to sell off last week.

Key Quotes

“For sterling to weaken markedly this week we will likely need to see more than what interest rate markets have already priced for the BoE MPC decision. A 50bp cut may suggest more urgency from the committee and thus would be sterling negative. Hints around the possibility of a move to negative rates, though unlikely, would be even more sterling negative.

Our base case is for a 25bps Bank Rate cut and a revamp of the Funding for Lending Scheme (FLS). With sterling positioning at pronounced short levels (source: CFTC data), position squeeze risks are apparent. However, we maintain our strategic 1.20 target for cable, as we have high conviction that UK economic data will deteriorate significantly over coming months.

We expect Forbes to be the only dissenter in an 8-1 vote for a Bank Rate cut on Thursday. From here, UK economic data is unlikely to display the full effects of Brexit until mid-August when we see July’s retail sales data. Last week’s largely redundant Q2 GDP showed a reasonable uptick in growth for pre-brexit Britain, driven by industrial survey data and service sector base effects.

The August inflation report will likely provide some extra academic groundwork to justify a Bank Rate cut. Ross Walker, of RBS UK Desk Strategy Economics, expects UK GDP growth to slow to significantly below trend rates – as soon as Q3 2016. If the MPC revises down its projections on a similar scale, then their modal GDP forecasts would be lowered to around 1.0% in 2017 and 2.0% in 2018. Projected currency weakness will likely shift inflation forecasts higher, but the growth outlook is where BoE policy thinking will focus.

We believe that sterling will remain weak for some months to come and may be very slow to recover once a base is finally established. Once the elastic between spot and fair value becomes stretched, GBP may gradually recover. This may be driven by a pick-up in FDI inflows as overseas investors pick up more cheaply priced assets in the UK. While this may make the funding of the current account deficit a little easier, the supply side of the economy may be damaged if inflows are limited to private and commercial real estate and productive capital isn’t financed.

Our medium-term target (2y plus) for EUR/GBP is 0.80 and 1.45 for GBP/USD. However, we expect sterling to retest recent lows (Short Cable, target 1.20) before recovery begins. How far it ultimately recovers is a function of the hit to the supply-side. If exit leads to high inflation and lower productivity growth, GBP’s long-term value will be lower. How the current account deficit reacts to recent exchange rate falls will also be important. Deregulation and trade deals, including those with the EU, will be important determinants.”