Sterling: turning Japanese

By:
Peter Garnham
Published on:

Following the plunge in the yen over the last few months, the pound looks set to be the next currency that devalues across the board as the Bank of England sets aside inflation targeting.

That certainly seems to be the message coming from the speculative community, where positioning in the currency has turned bearish for the first time in nearly six months.

Figures from the Chicago Mercantile Exchange showed speculators on the IMM were net sellers of $1.7 billion worth of sterling in the week to February 12, just prior to the release of the Bank of England’s quarterly Inflation Report.

Judging by the reaction to the Bank of England’s quarterly assessment of the UK economy last week, it is likely that those positions have been built up further.

 

 Speculators on IMM turn bearish on sterling  
 

Mervyn King, Bank of England governor, stressed the problems facing the UK economy are structural in nature and require supply-side reforms and a rebalancing away from consumption towards investment and exports. Monetary policy could therefore support demand, but would not help the economy’s structural adjustment.

Mansoor Mohi-uddin, head of FX strategy at UBS, says this suggests that the central bank is unlikely to restart its quantitative easing programme until at least July 1, when Bank of Canada governor Mark Carney replaces King.

At the same time, however, the Bank revised its growth and inflation target and now expects CPI to moderate towards its 2% target in 2016.

Normally, that would imply a tightening monetary policy bias at the Bank, but instead King said aiming to return inflation to target would result in undesirable volatility in growth and that the current inflation targeting regime allowed policymakers flexibility.

In other words, UK inflation targeting has gone by the wayside in the search for growth.

As Mohi-uddin notes, the Bank has signalled that it is prepared to allow inflation, which stands at an annual rate of 2.7%, to be above target for several more years.

That, he says is clearly bearish for sterling, as it erodes the safe-haven appeal of Gilts.

Adding to the pressure on the pound, Bank of England officials have been increasingly vocal over the value of sterling, and the effect that a weaker exchange rate could have in boosting the UK economy.

Indeed, some have drawn parallels between Bank of England officials’ recent pronouncements on the value of sterling and those on the yen from Japanese policymakers, who have come under criticism in the past few months for talking down their currency in a bid to stimulate the Japanese economy.

That of course has stoked the global currency war debate and led some to believe that action would be taken against Japan at the recent G20 meeting in Moscow.

Mervyn King has let it be known that he is willing to see the pound weaken, arguing that “if you want to allow countries to stimulate growth, you have to allow them to take the measures of a monetary or other kind which will have consequences on the exchange rate”.

Meanwhile, Martin Weale, a member of the Bank of England’s Monetary Policy Committee, said in a speech last week that he expected sterling would decline further and that while it may exacerbate inflation, it would help to rebalance the UK economy.

Weale argued that the Bank would “look through” the impact on increased import prices from “any further depreciation similar to that experienced in the last few weeks”.

Mohi-uddin says that is a clear message from the Bank of England that further sterling weakness is both likely and desirable.

“In our view the pound seems clearly at risk of following the yen and suffering the next large scale devaluation for a major currency,” he says.

Accordingly, UBS has issued a recommendation this week that clients buy a six-month sterling put/dollar call option with a strike of $1.4800.

GBPUSD now stands just below $1.55. If the Swiss bank’s bet were to move into the money, it is unlikely the Bank of England would complain.