Slippery Forward Guidance Spurs Sterling Profit-Taking

The emphasis on central bank forward guidance always seemed like shaky ground on which to rest monetary policy. After all, central bankers always try to influence investor expectations. However, as the UK is amply demonstrating, what is euphemistically called "time inconsistency" may limit its effectiveness.

Sterling has been hit by a wave of profit-taking by the shifting sands of the BOE signals. Recall the sequence of events. The recent Quarterly Inflation Report suggested a dovish stance. Then at the Mansion House, Carney warned that a rate hike could come earlier than the market had expected. Today, before the Treasury Select Committee, the signal is somewhere in between the two earlier statements. But, given the more recent hawkish signals, investors have been whipsawed.

Sterling and UK interest rates have fallen in response. The short-end of the curve, where rate hikes were most evident, has seen rates fall the furthest. The implied rate on short-sterling futures mostly 2-4 bp lower. 10-Year gilts are flat and not participating in the general bond market rally today which has seen U.S. 10-Year yields push back below 2.6%.

The ultimate takeaway is that the outlook for US monetary policy is data dependent. As banal as this may sound, this is not the case among the other major central banks. The Fed is gradually slowing its QE on a set path without regard to the high frequency data. The full implementation of the newly announced ECB initiatives is still a couple of months away (first TLTRO in September). The BOJ's aggressive QE continues apace, and the Governor has warned that core inflation may retreat toward 1% in the coming months.

Sterling's price action is the main dynamism in the foreign exchange market today. There has been a large build up of long sterling positions in recent weeks, encouraged by the divergence of monetary policy trajectories. As an example of the positioning, consider that the gross long sterling futures position is larger than the combined gross long position of the euro, Swiss franc, and yen. It rose from about 70k contracts a month ago to over 100k contracts as of early last week. It is the highest since late 2007, when sterling was above $2.00.

The pullback in sterling, which pushed it below $1.70 for the first time in three sessions, was not deep enough to wash out many longs. Instead, it appears new buyers entered and sterling quickly rebounded. The $1.7030-50 area offers initial resistance. The quick drop in sterling also helped lift the euro against the dollar and on the cross against sterling. The euro tested last week's high near GBP0.8025 before running out of steam.

Against the dollar, the euro, the sterling impetus was enough to offset the softer German IFO, and lift it to about $1.3625. Recall last week's highs were recorded in the $1.3635-45 area and that needs to be taken out to lift the tone. The euro's recovery since the middle of the month's test on $1.35 has been sufficient for the 5-day moving average to cross above the 20-day average today for the first time since May 12.

The German IFO is not surprising given the softness in recent survey data, like ZEW and yesterday's flash PMI. The consistent message is that the German economic locomotive is still pushing ahead, but it is losing some momentum and confidence in the future is waning. The expectations component fell to 104.8 after peaking in January at 108.9. The overall business climate measure fell to 109.7, which is also the lowest of the year.

The North American session features the Case-Shiller house price index. Generally speaking, the increase in house prices in the US appear to have peaked in Q4, and the pace of increase has slowed since last November. This pattern is expected to continue in today’s April report. New homes sales for May will be reported. After a somewhat stronger than expected gain in existing house sales reported yesterday, there is some optimism that new home sales could rise for the second consecutive month, for the first time since last September-October.

Several regional Fed presidents speak today. The Philadelphia Fed’s Plosser speaks before the equity market opens. He is a voting member of the FOMC this year and is seen as among the more hawkish members. NY Fed’s Dudley will discuss the Puerto Rican economy this afternoon. He is a permanent voting member of the FOMC and is seen as most aligned with Yellen. San Fran’s Williams speaks after the markets close. He is not a voting member this year and is more aligned with the doves at the Fed.