Could ‘defensive’ rate hikes crush the pound?

Could ‘defensive’ rate hikes crush the pound?

The news last week that the Bank of England had finally decided to reverse their post Brexit emergency cut, pushing the base rate back at 0.50%, was met with a nigh on 2% drop in the pound.

Most thought the move by the Bank was so widely expected that there was an element of ‘buy the rumour, sell the fact’ at play in the pound falling.

Leaving that aside though, the defensive nature of the move was also a reason why the pound reacted so negatively to the news.

So, the sell-off back to near 1.3000 on the GBPUSD and corresponding rise back towards 0.9000 in the EURGBP were fuelled by the comments from the Bank; issuing a warning that any further rate increases will be measured and gradual. Given the current circumstances of course they will have to be.

Quite honestly, though, a 25bp rate increase isn’t going to deliver any impact on inflation…

For one thing, inflation in the UK economy is not transitory, it’s structural, and whilst Mark Carney and the Old Lady might like to blame the high levels of UK inflation on the weak pound, it is entirely disingenuous of them to do so.

The pound, as it stands right now, is still less than 10% of its pre-Brexit levels.

Still, that’s what they perceive to be the root cause of the problem: the low level of the exchange rate. But what about the output/productivity gap? High levels of government and private debt, or an economy that’s so reliant on services because we simply don’t make enough of what we consume?

All of the elements would play into a rise in interest rates.

Britain is for sure one of the most consumer/services dependent economies within the G20 and if rate rises are to be truly effective then there will need to be many more of them. In any case such action is unlikely to drive the pound high enough to offset the damage that could be inflicted on the economy, and the consumer, not to mention the negative effect it could have on the housing market and the debt burden there.

The problem in all this is right now is the Brexit issue and how uncertainty there is also hampering the Bank’s ability to act firmly enough.

Now of course, should we get a deal from the EU that removes such uncertainty then the Bank can and surely will act more aggressively on monetary policy.

However, as of yet there’s simply no progress on that issue and there’s unlikely to be so in the coming months either, so a more aggressive stance by the Bank is simply not possible right now.

The risks to them trying to push the pound higher and failing are simply enormous. I think the MPC surely know this anyway, but that might not stop them digging their heels in if inflation doesn’t start to come down as their current forecasts suggest.

The main point in all this from the markets perspective is that judging by the reaction last week, the knives are already being sharpened, ready to have a go at slicing up the pound. Indeed, the words ‘defensive’ and ‘too little, too late’ are already being banded about.

Make no mistake the move last week was not about inflation; it was about defending the currency to try and solve the problem, and if that’s the real game in town, then more is surely needed.

But can the Bank afford to act again and suffer another similar reaction to the pound like we saw last week?

I really don’t think they can and with the dollar looking like it might catch even more of a tailwind into the end of Q4, this is not good timing for the Bank.

In fact, one of two people has already remarked to me that the Bank is merely raising rates now so they have something to cut again if the worst happens.

Now, if word truly gets out on that idea, then the whole policy embarkation will be sunk before it’s even dived off the board anyway.

There’s not a whiff of currency crisis out there just yet, but I don’t think things will need to stew for long before the smell leaks out of the kitchen as it were.

So if you thought the moves lower in the pound following the Brexit vote last year are over and done then I suggest you think again…

That may just have been the whiff from the starter and the main course is yet to come.