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August 10th 2011: Preview -  King to keep Bank of England pessimism in check

 

It is very difficult to see where any good news will be found in the latest Bank of England inflation report. Growth forecasts are likely to be downgraded again and the overall tone is likely to be one of pessimism.  Confidence will, however, be vital for the financial sector and the economy as a whole.  Governor King will, therefore, have a strong incentive to play-down the market’s worst fears, even though this may just delay the inevitable.  The UK currency should also be able to resist heavy selling from growth warnings given that expectations have shifted and markets have already priced out interest rate increases over the next 12 months. 

Sterling will still be vulnerable to heavy selling within the next few weeks and selling into strength remains the best approach with the risk/reward ratio favouring small short Sterling positions running into the report.

The report will contain the bank’s latest growth and inflation forecasts and will also give the implied interest rate forecasts over the next two years  Two member of the MPC recently commented on the possibility of another recession in the UK economy. Since then, the economic data has got worse while the global economic outlook has deteriorated sharply. There are, therefore, likely to be increased warnings over a renewed downturn and 2011 growth forecasts are likely to be cut for the sixth time with a reduction for 2012 also guaranteed.

Commentary on growth, quantitative easing and the banking sector will be extremely important for Sterling.  Interest rate forecasts have already been lowered substantially further with markets not pricing in any interest rate increases over the remainder of 2011 and indeed not into 2012 either. Sterling will, not, therefore, be vulnerable to a  shift in interest rate expectations, especially with the Fed also pledging on Tuesday to keep zero interest rates until 2013.

Remarks on quantitative easing will also be extremely important in the report.  Sterling will be subjected to more substantial selling pressure if the report and Governor King’s press conference suggests that further quantitative easing is imminent and there are increased fears surrounding the UK banking sector, especially as safe-haven support would be severely compromised.  

MPC members Fisher and Miles have stated that further quantitative easing could be warranted if the economic conditions deteriorate. Headline inflation is still way above target, but fears over the economy have certainly increased with the global economic backdrop and riots liable to trigger a further deterioration in confidence.

These fears will tie-in closely to the third area of focus which will be the banking sector.  The Bank of England in its previous inflation report warned that underlying weakness in the banking sector was a major barrier to higher interest rates. Wholesale funding costs will have moved higher since that report and the equity valuations of the major banks have come under severe pressure over the past month as fears over the European economy have increased.

Lending levels were already depressed and will take another beating over the next few months as the banks also look at the potential for spiralling bad debts from the Euro-zone. The government’s budget policies will also be in disarray if the UK economy slides back into recession.

In this environment, there is a high risk that further support could be needed and that the Bank of England will resort to additional quantitative easing. Nevertheless, with bond yields already at historically extremely low levels and bank capital adequacy levels improved, the bank is likely to stay in wait and see mode in the short term.

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