Sterling effort against QE3; policy mix positive for pound
For those wondering why the prospect of further monetary easing is not weighing more heavily on the pound, there is a relatively simple explanation.
After the release of the June minutes of the Bank of England’s Monetary Policy Committee (MPC), analysts moved to nail on further quantitative easing (QE) in the UK. According to a Reuters survey of analysts, the median probability of more action from the Bank at its July 5 meeting stands at 80%, with 98% believing that further QE will occur at some point.
However, Adam Cole, head of FX strategy at RBC Capital Markets, says he is reluctant to see this as a substantial downside risk for sterling.
Indeed, the Bank has suggested the impact on sterling of previous bouts of QE was limited to a small announcement effect.
After previous announcement effects (see chart), sterling in fact rallied strongly and broadly, once the first and second rounds of QE got under way.
UK QE and GBP - sell the rumour, buy the fact
|Source: RBC Capital Markets, Bloomberg|
“To the extent that QE3 in the UK is now fully discounted, arguably the announcement effect has already happened, perhaps rationalizing why the pound is down against every G10 currency with the exception of EUR over the last month,” says Cole.
However, beyond the kneejerk reaction, he disagrees strongly with the conventional wisdom that QE is necessarily negative for currencies.
Cole argues that in the very long run, higher inflation and a loss of competitiveness would be a conventional route to currency weakness. However, recent evidence is that high inflation, at least within limits, tends to be positive, not negative, in FX.
In the short term, QE can drive currencies down by reducing future rate expectations. But while this was true during the first and second rounds of QE in the UK, when the forward curve was pricing in sizeable rate hikes, it is less clear now. Indeed, the opposite is the case, with markets 50% priced for a 25 basis point rate cut in the UK by the year-end.
Cole notes that the MPC discussed alternative easing measures, including cutting rates, in June and rejected them.
“Our view remains that QE and rate cuts should be seen as substitutes not complements and as such, as the probability of QE rises, so the probability of conventional easing falls,” he says.
“All of the above suggests that, at worst, further QE will not be negative for the pound and shifts in expectations for the overall stance of policy may well turn out to be sterling-positive.”
RBC believes that, given the fact that the prospect QE3 in the US is much more in the balance – analyst surveys put it at 50% – playing the upside in GBPUSD spot is not an attractive proposition.
Instead, the bank recommends taking advantage of the sharp pullback in GBPUSD vol during the past two weeks and buying, for example, three million $1.61 calls (spot ref $1.5675; vol ref 7.9%).
Alternatively, the banks says, the GBP leg only is better expressed through a risk-neutral sterling cross, such as short EURGBP.