On Thursday, the Bank of England is widely expected to cut rates by 25bps to 5.00 percent, as tight credit conditions and a crumbling UK housing sector may prove to be frighteningly similar to the US. Conditions in the UK have steadily gone from bad to worse, and are becoming eerily reminiscent of the beginning of the collapse of the US housing sector. While inflation is well above the Bank of England’s 2.0 percent target at 2.5 percent and upside risks remain given the resilience of commodity price gains, the Monetary Policy Committee has little room for maneuver. Despite two 25bp rate cuts since December and continuous efforts to boost liquidity in the money markets, banks remain reluctant to lend.
What Are The Markets Facing?
On Thursday, the Bank of England is widely expected to cut rates by 25bps to 5.00 percent, as tight credit conditions and a crumbling UK housing sector may prove to be frighteningly similar to the US. Conditions in the UK have steadily gone from bad to worse, and are becoming eerily reminiscent of the beginning of the collapse of the US housing sector. While inflation is well above the Bank of England’s 2.0 percent target at 2.5 percent and upside risks remain given the resilience of commodity price gains, the Monetary Policy Committee has little room for maneuver. Despite two 25bp rate cuts since December and continuous efforts to boost liquidity in the money markets, banks remain reluctant to lend. Nationwide and the Royal Bank of Scotland are among some of the banks that have raised mortgage rates in order to deter borrowing and limit exposure to that kind of debt. These restrictive conditions have only added pressure to the deterioration of the UK housing market in a high supply/low demand environment. During the month of March, HBOS house prices dropped 2.5 percent – the sharpest decline since 1992 – while mortgage approvals have dwindled down to 73,000 in February – the lowest since 1995 – from 120,000 in early 2007. The minutes of the Bank of England’s March meeting showed that the MPC thought a “further tightening of credit conditions remained possible” and that “sentiment had deteriorated in the money markets and longer-term credit markets.” With these conditions coming to fruition and exerting significant downside risks for the UK economy as a whole, the Bank of England is expected to cut rates by 25bps to 5.00 percent. However, there is a risk that über-doves like David Blanchflower and John Gieve will vote for a 50bp reduction, though we will not know for sure until the release of the minutes from the MPC meeting later in the month.
Bonds – Long Gilt Futures
Gilts have bounced off the recent lows as daily technicals are reaching oversold levels, and with the Bank of England expected to cut rates on Thursday, the contract could continue to gain toward resistance near the 110.31/36 level. On the other hand, indications that the central bank will not make aggressive rate cuts in the future could weigh on Gilts and push them down toward trendline support at 109.
FX – GBP/USD
The GBP/USD pair has fallen over 200 points this week as traders began pricing in an expected rate cut by the BoE. The move was accelerated when HBOS released their March home prices, showing a decline of 2.5 percent, signaling that the deteriorating housing market is far from stabilizing. Increasing speculation that the MPC may cut rates deeper than the expected quarter point sent the pair to test 1.9650. GBP/USD has consolidated since finding support from a better than expected increase in industrial and manufacturing production. However, the recent break below the 50 Day SMA, has left the pair without any major technical support levels until 1.9570 (seen in Jamie Saettle’s technical report), leaving considerable downside risks. An inline reduction is expected to continue to weigh down the pound, with a 50bp cut possessing the potential to break below near-term support levels. If inflation concerns and the recent surprising fundamental data leave the central bank reluctant to cut rates, Cable may look to test resistance at 1.9900.
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Equities – FTSE 100 Index
The FTSE 100 continues to consolidate its recent rally, but with heavy resistance looming above near the psychologically important 6,000 level and the 100 SMA at 6,033, the index will have trouble making further headway. Furthermore, risk aversion trends remain the primary driver of equity market activity, and with the Q1 earnings season starting, traders may start to flee en masse to safe-haven assets soon. Looking ahead the Bank of England’s rate decision could boost shares during intraday trading, but in the past, the days following rate cuts usually lead to declines in the FTSE 100. As a result, the index is likely to pull back toward 5,850.
Written by Terri Belkas and John Rivera, Currency Analysts, DailyFX.com