Pound Sterling: Bank of England Surprise Could Trigger Big Gains or Losses

- GBP shows nerves ahead of Bank of England announcement
- New quantitative easing in excess of £100BN to weigh on GBP
- Talk of negative interest rates could weigh on GBP
- But quantitative easing less than £100BN to boost GBP

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The British Pound will today take direction from the Bank of England which will announce the outcome of their latest policy meeting at 12:00 BST, with the market expecting another £100BN in quantitative easing to be announced.

Movement in the Pound will be minimal if the Bank meets expectations, however there is a chance for swings in either direction if the Bank deviates from this expectation.

If the Bank announces a quantitative easing (QE) package in excess of £100M the Pound would likely fall while anything less could well prove supportive.

Judging by the movement in Sterling - which went broadly lower over the course of the past 24 hours - traders are erring on the side of caution, suggesting a building in expectations that the package will come in at the top end and therefore won't be supportive of the currency.

"June BoE meeting is more important than you may think. How much QE is further increased by will matter for weekly pace of gilt purchases. £100bn not enough to sustain current pace & may be seen as relatively hawkish. £150bn+ needed to keep gilt yields & GBP anchored lower," says Viraj Patel, a markets strategist at Arkera in London.

The Pound-to-Euro exchange rate has fallen from a week high of 1.1219 to trade back at 1.1157 while the Pound-to-Dollar exchange rate has fallen from 1.2686 back to 1.2554.

Above: GBP/EUR price action over past 36 hours

The Bank's quantitative easing programme sees the Bank effectively print money to buy government debt, which there is now a lot more of thanks to the coronacrisis. This debt is issued in the form of bonds - or gilts - that pay the investor a yield for the duration of its lifetime.

But, the greater the demand for these bonds the lower the yield paid on them. This is where the Bank of England comes in: by creating significant demand for these bonds the yield has fallen, with the yields of some bonds actually falling into negative territory for the first time ever in May.

The yield has long attracted significant volumes of foreign investor capital, but with yields so low that attraction is waning. This has implications for the Pound as that foreign investor demand for bonds has been a source of support, remove that support and the Pound looks exposed.

Therefore, the greater the quantitative easing at the Bank of England, the lower bond yields will likely be and the less demand there is for Sterling.

"Our view thus remains that GBP is amongst the more vulnerable of the G10 currencies to the consequences of COVID-19, not only because the damage to public finances is larger in the UK than in most other DM countries (the 2020 fiscal deficit is put at 16% of GDP), but also because the UK has the largest foreign financing requirement in G10. This reliance on foreign inflows renders GBP more vulnerable to the depressing effects on local yields from 24 the BoE’s QE," says Paul Meggyesi, Head of FX Research at JP Morgan.

JP Morgan are expecting QE to be increased from £200bn to £300bn, equivalent to 14% of GDP, by the Bank.

But it is not just the quantitative easing programme investors will be wary of. There are elevated expectations for the Bank to prepare markets for further cuts in the interest rate, that could see the UK's basic interest rate fall to 0%, and then lower into negative territory (NIRP).

"Risks to the currency would likely stem from the Bank announcing a package in excess of £100BN, or suggesting a further interest rate cut to 0% or below (NIRP) is possible in coming months," says Jordan Rochester, foreign exchange strategist at Nomura.

Rochester says the Pound could undergo big moves if the size of the quantitative easing is much greater or larger than the £100BN the markets are expecting, particularly if a smaller £50BN package is announced (Sterling to go higher) or £200BN (Sterling to go lower).

Nomura are forecasting the Pound to grind lower against the Euro over coming weeks and have a forecast target of 1.0870 in mind.

The door to aggressive easing at the Bank was opened wide on Wednesday when it was announced by the ONS that the UK's annual inflation rate had fallen to 0.5%, putting it at its lowest since 2016 and well below the Bank's target rate of 2.0%.

The Bank is mandated to achieve inflation at 2.0% and can do so by boosting the economy via cutting interest rates and raising quantitative easing, however inflation running hot above 2.0% would force the Bank to raise rates and cut quantitative easing.

With inflation clearly at a level that is conducive to further easing the Bank will feel it has significant leeway to become more active, and we expect some of the weakness in Sterling exchange rates over the past 24 hours are linked to that inflation release.

"Driven by lower oil & gas and slashed retail prices, inflation dropped further in the UK. Weak demand and cheaper input prices suggest some disinflationary momentum. Therefore, the Bank of England (BoE) is ready to ramp up its asset purchases. Further monetary easing and an uncertain Brexit outlook justify our Bearish short-term GBP stance," says David Alexander Meier, an economist at investment bank Julius Baer.

Interest Rates Could Eventually go Below 0%

The issue of negative interest rates was discussed by Bank of England members at various points in May in an apparent attempt to condition markets for a potential cut to below zero.

This talk, as well as rising Brexit trade negotiation anxieties, could have been a contributor to the Pound's underperformance in May.

However, the Bank pared back on the threat to go below 0%, with Chief Economist Andy Haldane hinting that such an outcome might not be necessary owing to signs of improvement in the economy.

Therefore, talk of negative interest rates has the potential to spook the markets and trigger potential losses in Sterling.

"We expect £300 billion more to be added to APF over the next 18 months – likely £100 billion in June, November and May 2021. However, to support inflation back to target, as quantitative easing becomes less effective with higher savings and reduced issuance, we expect the MPC to do more, likely signalled in August and implemented in November: cut Bank Rate to 0% (ZIRP) and provide bank funding at a negative rate (NIRP). In our bear case, we expect Bank Rate to go to -50bp in 2021," says Jacob Nell, Head of European Economics at Morgan Stanley.

Morgan Stanley expect GBP/USD to trade flat this year and be a relative underperformer as the Bank of England is due to cut rates to negative and a Brexit trade deal is unlikely to be achieved this year.