The UK, QE and the Pound

The Bank of England minutes from the February meeting were released on Wednesday and surprised the market because two members of the Committee (noted dove Adam Posen and David Miles) had voted to extend asset purchases by GBP75bn, more than the GBP50bn that the consensus wanted.

This caused an immediate knee-jerk reaction in the pound, which dropped from 1.58 to below 1.57 vs. the US dollar, while EURGBP punched through resistance at 0.84 and is now testing 0.8450. The move may have been caused by the market thinking that the MPC is in dovish mode, but is this view justified?

It's worth taking a deeper look at the minutes to try and sense where the Bank of England really stands. Although the Bank noted that growth had picked up in recent months, mostly as a result of the ECB's LTRO programme that started in December, it also said that the sharp up-tick in PMI surveys in Europe and the US was surprising and may have been down to inventory re-building, which would not be sustainable.

The ECB has said that it will take some time for us to know the economic impact of the LTRO, but if its effect are not as profound as some expect then we could see growth disappoint in the coming months. This is one of the risks the Bank sees to UK growth going forward.

Regarding the outlook for inflation, it noted that prices so far have fallen as expected, but there remains “substantial uncertainties” around the path of inflation in the medium-term in both directions. Tensions in the Middle East could keep oil prices elevated, however, weak wage growth may continue longer than expected thus keeping a cap on inflation as consumer spending remains weak.

To make things even more complicated, because the UK has had persistently high inflation for some time, if prices fall steadily then more QE may not be justified as it could boost growth as real incomes (adjusted for inflation) start to rise, thus boosting consumer spending.

So the Bank's crystal ball is malfunctioning, and essentially these minutes say to us that the Bank doesn't know whether further monetary stimulus will be needed or not. However, if risks to growth increase then more QE is at the ready, and likewise, if the Bank believes the recovery has self-sustaining momentum then it can withdraw stimulus as required.

So you could say that the Bank is neutral on more QE at this juncture. Even the fact that 2 members wanted more than GBP50bn of QE this month doesn't tell us that much since the difference between GBP50bn and GBP75bn is only a small impact on the economy that it doesn't tell us what Posen and Miles will vote for in the future.

So what does that mean for the pound? Essentially if the fall in the pound on Wednesday is down to a “dovish” MPC then the market may have got that wrong. GDP data for Q4 is released on Friday and is expected to show a 0.2% decline on the quarter. Could the UK pull a France and actually surprise to the upside? It is not beyond the realm of possibility as growth seemed to pick up in December, which has helped to fuel some of the strength at the start of 2012. If this situation were to play out then we could see the pound quickly rebound. In GBPUSD 1.59 would be the key resistance level to note, while in EURGBP, 0.8400 is now key support.

There is some expectation of more QE in May, but a stronger than expected GDP report on Friday for Q4 could cause some investors to reverse their view, which may lend some short-term support to the pound. This does not mean that we believe the pound will strengthen in the long-term; it's just that in the short-term it looks oversold relative to the Bank of England's view that future QE is uncertain.

Our favourite sterling trade is short EURGBP. It is close to 0.8475 - 100-day sma and a key resistance level. A good entry zone is around 0.8480-0.8510. The first target is 0.8450 and then 0.8400. You will know if you are wrong if EURGBP continues to climb through 0.8550, so 0.8560-80 could be a good stop-loss level.

EURGBP Daily chart