With Non-Commercial Sterling short positions hitting record levels but GBP still rising, it is worth taking some time to consider the underlying dynamics that are fueling this disconnect between positioning and price action, starting first of all with central bank policy.

BOE Take Hawkish Turn

At their recent meeting, the BOE took a hawkish shift with one member, Forbes, actually voting for a hike while “some members noted it would take relatively little further upside news for them to consider a more immediate reduction in policy support”.  The phrase “some members” suggests that, not including Forbes, there are at least two other members on the verge of voting for tightening.

In terms of the latest data, the Monetary Policy Committee (MPC) also appeared less concerned with weakness in survey readings such as Retail Sales and PMI data sets. Alongside casting doubt on the reliability of Retail Sales as an indicator, the bank also highlighted that any slowdown in consumption should “be viewed in the context of other indicators” where recent indicators had “raised the possibility that overall aggregate demand growth might hold up even as consumption slowed”.

MPC Reaffirm February Projections

Consequently, the MPC made the case that underlying the judgements behind the February projections remain valid and that the conditioning assumptions supporting these, specifically “that there will be some modest withdrawal of monetary policy stimulus over the course of the forecast period” remain valid. Indeed, the MPC appeared comfortable referring to the more hawkish rate path displayed in the February projections in light of the recent uptick in financial conditions.

Clearly, the MPC has turned hawkish here but with the caveat of remaining data dependent. As such, the focus is now heavily on the upcoming inflation figures for February which are expected to see CPI moving back above the bank’s 2% target for the first time in four years.  A print above this level is likely to further fuel the GBP rally.

The minutes of the meeting did, however, reveal some divergence in the time horizons used when discussing tighter vs. looser policy. The MPC flagged concern for “potential uncertainty over future trading arrangements to affect materially economic decision making” but also emphasised that they would respond to this if necessary.

MPC Focusing On Short Term

This line of the discussion was in contrast to the shorter-term focused concerns that positive news could fuel “more immediate reduction in policy support”. To summarize here, the MPC aren’t considering the longer term negative risks linked with Brexit but are willing to deal with them if required and are for now focusing their Article decision process on the performance of the economy in the short term.

However, given the current voting of one member in favour of a hike, and the likelihood that at least two others are on the cusp of doing so, there is very little priced in for a rate hike at the coming May and June meetings.  The prospect of “more immediate action” based on incoming data raises hawkish risks.

BOE Overlooking Pay Growth

Last week’s employment data showed weakness in pay growth but a simultaneous fall in the unemployment rate with private sector regular earnings unchanged in January and revised lower in December.  Weakened pay growth despite lower unemployment supported the BOE’s judgement in the February Inflation Report that there was a level of spare capacity in the economy which was greater than anticipated.

Notably, Both Forbes and McCafferty signaled that they didn’t agree with the rest of the MPC in February with the BOE revising lower the estimate of the equilibrium level of unemployment to 4.5%, suggesting 4.75% as more appropriate.

Despite volatility in monthly numbers, the fact that declining unemployment is not seeing stronger wage growth reaffirms the judgement of spare capacity in the economy. However, it is perhaps still too early for second round effects from stronger inflation to have fully passed through to wages.

This is especially true as inflation has only started to accelerate strongly from January. Importantly, though the MPC minutes highlighted that the MPC will continue to closely monitor pay growth, weakness was not concerning enough to restrain the hawkish tone of the March meeting.

Politics In The Spotlight

Outside of the central bank environment, politics is once again coming into focus with the government having now gained parliamentary approval to trigger Article 50. Simultaneously, the SNP leader Nicola Sturgeon has also declared her plans to hold a second Scottish independence referendum. Approval for the triggering of Article 50 passed smoothly without any significant changes to the bill, keeping the government on course to trigger Article 50 by the end of March.

The government confirmed today that Article 50 will indeed be triggered on March 29^th. The triggering is now well priced into GBP and at the moment suggests that the market is looking for some sort of compromise between a hard and soft Brexit with GBP remaining supported. However, the risk of a Hard Brexit is not fully priced in. 

News of the confirmation has fueled a selloff in GBP however, with positioning at record lows, it is difficult to see a fresh leg of sustained downside at this level. Sterling has been struggling to break down on bad news over the year so far and has instead reacted more to upside news, fueling rally. This is visible in the higher lows put in from last year’s flash crash low.

Sturgeon Throws Uncertainty on The Political Outlook

The announcement by SNP leader Sturgeon that the SNP will pursue holding a second Scottish Independence referendum adds further uncertainty to the outlook. So far, May has rejected calls for a second referendum highlighting that a campaign would be divisive while she is currently working on delivering the result of the EU referendum.

In terms of market reaction, while Scottish independence is not being thoroughly considered at this point, it does still add to the uncertain political environment in which the BOE might be expected to refrain from tightening. However, further Sterling weakness, fueled by the uncertainty, would increase the pass-through of inflation pressures, increasing the need for the BOE to tighten.