Sterling: What's The BoE Thinking?

This is the big week for UK economic data. Tuesday's firm CPI figures were followed by somewhat better-than-expected employment data today and the MPC minutes. The slew of data concludes Thursday with July's retail sales, which are expected to be soft (Bloomberg consensus: -0.1% on headline).

The high frequency data does not change the overall picture of the UK economy. It has contracted for three consecutive quarters through Q2's 0.7% contraction, which the MPC minutes echoed BoE Governor King in playing up one-off factors. However, most of the forward looking data warns that the UK economy appears to be declining in Q3 even if it's at a slower pace.

Easing References
The MPC minutes also dropped the explicit reference to rate cuts. King had already played down that option in favor or gilt purchases and funding for lending. The BoE is seeing some success in the scheme and noted that a number of banks have reduced lending rates for mortgages and small businesses. There was also discussion about extending the gilt purchase program (QE). Although no decision was made, further gilt purchases may be announced before the current program ends (Nov). The BoE's gilt purchases amount to roughly 25% of GDP. Fed bond purchases, in comparison, have been about 15% of GDP, while the ECB bond purchases are closer to 3% of GDP.

Counter intuitively for many participants who expect QE to be negative for a currency, sterling's strength is a head wind for the UK economy and it was recognized as such in the MPC minutes. Since the middle of last year, sterling has appreciated almost 9% on the BoE's broad-trade weighted measure. This is tantamount to some degree of tightening.

The BoE expressed concern that sterling's strength was curbing export growth and the re-balancing process. Since June 2009, when exports bottomed, they rose about 31% through last October. Since then exports have fallen almost 8%.

U.S. Exports
In comparison, the U.S. dollar has appreciated 7% on the Fed's broad trade-weighted index since the middle of last year. U.S. exports have risen almost 50% (48.8%) since the early 2009 lows (recall Obama had set a goal of 50% growth in exports during his administration) and have risen about 4% since the Fed's trade-weighted dollar index bottomed.

Despite pursuing QE, the BoE is frustrated with the strength of sterling. On one hand, this dovetails well with our inductive argument that, not withstanding economic theory, QE has not been negative for the currencies of countries that pursue it. On the other hand, there is not much the UK appears prepared to do to resist sterling strength. Part of sterling's strength, after all reflects the euro's weakness.

Against the dollar, sterling is flirting with its 200-day moving average, which comes in near $1.5721. Since the beginning of Q3, sterling has toyed with this moving average almost a dozen times and has yet to close above it (though intraday violation has taken place). This is occurring with the $1.54-$1.58 trading range that has confined the price action for two months.