The Bank of England meets tomorrow. It is way to early to seriously look for a change in policy. At most, MPC member McCafferty may abandon his formal call (dissent) for an immediate rate hike. He has done this before. We suspect if the hawk does rejoin the majority, it has no more significance than his dissents.
Why has sterling performed so miserably? There are two main drivers. First, the economic data has disappointed and investors have been pushing out their expectations of the first hike. It has shifted from late-Q2 to late-Q4. Second, there is concern about a referendum on EU membership that could be held in May.
The UK has a full economic calendar next week. Inflation, employment and retail sales are the main features. The risk is for continued soft data. However, the market appears to have largely adjusted to the slower growth profile that the recent string of data indicated. On New Year’s Eve, the December 16 short-sterling futures contract implied a 3-month yield in 12-months’ time of 104 bp. Yesterday it made contract highs to imply a 74 bp yield.
The March contract implied a yield of 64 bp at the end of last year and 60 bp at close yesterday. The spread between the two contracts fell to 16 bp yesterday. Barring the pricing in of a rate cut, we suspect there is not much more scope for spread compression. Combined with our technical analysis, we suspect that the decline in short-term UK rates is nearly at an end.
The US two-year premium over the UK peaked at 46 bp on December 29. This is the largest US premium since 2000, when it peaked just below 50 bp. Thus far this year, the spread has moved sideways. It is at 42 bp now
If the first leg of the sterling bear case may have nearly run its course, what about the other leg, the referendum? The news stream is likely to improve in the coming weeks. Note that the predictive markets (where people can wager on event outcomes) expect UK voters to approve remaining in the EU 3:1.
The key event is the EU Council meeting February 18-19. Negotiations are expected to be wrapped up then. Contacts report that the EU is likely to make most of the concessions UK Prime Minister Cameron is seeking. There even seems to be a compromise in the works about work-related benefits to EU workers who move to UK. In the lead up to the meeting, we expect more supportive comments and guidance that may ease anxiety about a Brexit.
To be sure, there is no reversal pattern in sterling. There are no divergences in the RSI or MACDs. No downtrend line has been violated. Nevertheless, we suspect that the rubber band has been stretched and is nearly ready to snap back.
Sterling has fallen in nine of the last eleven sessions coming into today. Speculators in the futures markets had reduced their gross short sterling exposure to its lowest level last year in late-September at 43.7k contract. In early November, the gross short position was still small at 45.8k contracts. It stood at 56.3k contracts in the middle of December and 75.2k as of January 5. This is a six-month high.
There is a risk then for a near-term short-squeeze, which may follow tomorrow’s BOE meeting. There are two levels to watch indicate that such a short-squeeze, which again, the technical evidence remains elusive. First is the five day moving average. It is near $1.4515 today. Sterling has not closed above this average since December 28, when the latest leg down began. The other level is about a cent higher. It corresponds to a down trendline drawn off the December 14 high and corresponds to some congestion from the end of last week and the start of this week.
This is not a recommendation to buy sterling. Discipline requires waiting for evidence that one trying to catch a falling knife. This is a warning that we may get such evidence shortly. Be prepared. Have a strategy. Stick to it.