WISE MONEY

Another week begins, and the spotlight passes from one central bank head to another – Sir Mervyn King of the Bank of England. In the past two weeks the markets have watched Fed Chairman Bernanke speak about interest rates and possible further quantitative easing.

Last week ECB President Trichet used language that indicated rate rises are just around the corner (sending the Euro markedly higher against the Pound and Dollar) and this week it is the turn of Bank of England and Mervyn King with the monthly MPC meeting scheduled this week.

After last month minutes showing three members voting for a rate rise, Sterling has enjoyed a bounce against the Dollar – if not the Euro – and if the Bank does decide to raise rates we can expect further gains.

However, King seemed to rule out any symbolic rate rises in the inflation report last month and given the current spike in crude oil stemming from unrest in the Middle-East, the doves on the MPC will be stressing that the UK economic recovery cannot be put in jeopardy by raising rates.

King has also drawn criticism from the city with comments over the weekend that city institutions are too short-term orientated.

Given that Mr King once said he thought central banking should be a dull subject, the thinking may be that he seems to be overplaying his hand and that could hurt the credibility of the bank if he is seen to be overly political.

The ECB meeting has been the catalyst for the recent Euro strength, but any rate rise in the Eurozone would probably only be beneficial for the Germans.

The struggling periphery PIGS nations will certainly not welcome any move – especially the Spanish whose mortgages are prices from one year Euribor – which jumped 14 basis points immediately after Mr Trichets announcement.

In the face of rises oil prices, which acts as a global tax, raising rates at the behest of the Germans risks derailing any sustainable recovery in nations trying extremely hard to get their public (and private) finance back in order.

UK interest rates will rise in May hints Bank of England Governor Mervyn King in inflation letter.The Bank of England Governor, Mervyn King, has signalled that interest rates may rise three times before the year is out, hitting 1.25pc by December.

Mr King came as “close as he can” to endorsing market expectations that the base rate, to which lenders’ own rates are tied, will start to climb from its record 0.5pc low in May, said economists.

They seized on a key passage in the Governor’s latest letter to the Chancellor explaining rising prices, after annual inflation hit 4pc in January, double the target and its highest level in over two years.

Mr King said the consumer prices index (CPI) measure would climb closer to 5pc in the next few months.

However, he said, the Bank’s Monetary Policy Committee (MPC) believed inflation will be around target, at 2pc in two or three years, “under the assumption that the bank rate increases in line with market expectations”.

Interest rate futures are pricing in a first 0.25 percentage point rise by May and another every three months for the next two years or so. That would signal a 0.75 percentage point increase by the end of 2011.

The Bank’s quarterly inflation report will update its forecasts for growth and prices to give more indications as to when the base rate will finally rise, after two years at 0.5pc.

The Pound yesterday hit a five and a half month high against a basket of currencies as investors bet that rates will rise sooner rather than later.

The uncertainty the Bank builds into its forecasts gives it room to alter its expected course. However, it is under pressure to raise rates given over-target inflation. Two MPC members were shown in the last set of minutes to have voted for a rate rise.

Yesterday morning, Wise Money suggested that the money markets would be quiet- and we were spot on. The euro slid for a fourth consecutive day as data showed German factory orders fell more than analysts forecast in December after jumping five times more than economists expected in the previous month.

Orders adjusted for seasonal swings and inflation dropped 3.4 percent from November.

Sterling posted modest gains yesterday as short term interest rates increased.

The two-year UK gilt yield climbed the most since February 2009.

The implied yield on short- sterling futures contracts for December 2011, which anticipates where short-term interest rates will be, rose four basis points to 1.74 percent as traders added to bets for higher borrowing costs.

The Bank of England’s Monetary Policy Committee is scheduled to meet on Thursday and is forecast to keep its bond-purchase plan at 200 billion pounds and leave benchmark rates at a record low 0.5 percent, according to all analysts surveyed.

Reports later this week are forecast to show U.K manufacturing expanding for an eighth month in December.

Output is forecast to show a rise of 0.4 percent in December after a 0.6 percent gain in November, both scheduled for release on February 10th.

The money markets have been surprising muted in the last week despite market moving data. Chinese exports in November rose by a staggering 34% from a year earlier and this pushed up their trade surplus to $22.89 billion.

Normally this would have led to a surge of risk in the markets as investors respond to the healthy data- the main beneficiaries of this would be the Euro and the Aussie Dollar and selling of US Dollar.

However investors have taken a wait and see approach- this could be due to concerns still awash in Europe but more probably it is related to fears that China’s CPI and PPI due out on Sunday is expected to be much higher than anticipated and thus it will lead to a rate rise.

Although China is leading the drive to recovery there is always the concern that their economy may overheat and it is precisely these concerns that are holding back the move to risk.

Yesterday the MPC decided to hold rates and leave stimulus measures untouched- we will need to wait two weeks for the BoE minutes to see the thinking behind the decision.

Also the minutes will highlight the sentiment in the MPC- will the hawk/dove divide widen?

The Pound is slightly up this morning against the USD and EUR- interestingly there was an article in the Telegraph trumpeting the pound for 2011.

According to Barcap they see the pound being the star of 2011 and GBP/USD hitting $1.82 and GBP/EUR 1.28.

Wise Money cant remember the last time the pound was talked up!

The reasoning behind the strength will correlate with gains in the FTSE and the deliverance of the cuts to the deficit boosting the pound…mmm tell that to the revolting students.

Those who follow the “buy the rumour, sell the fact” mantra would have done very nicely yesterday after the publication of the latest Bank of England inflation report. During late trading on Tuesday, Sterling began to fall back on the rumour – of a greater than expected dovish stance by the MPC – moving back below 1.60 in cable and towards 1.15 against the Euro.

But the reality was of a distinctly hawkish tone.

In his press conference after the announcement, BOE Governor Mervyn King set out the Bank’s forecasts for inflation over the next few years.

In it he suggested that inflation will be persistently above target before falling back (how convenient!).

It was a sea change in the perceived stance of the MPC that took the market by surprise.

Both the Pound and gilt yields leapt on the announcement, as Mr King also sought to reassure the markets that differences in opinion among MPC members are to be encouraged.

Once again Andrew Sentence voted for a rate rise, Adam Posen for more stimulus and the rest for no change- and has been broadly interpreted as a move by the bank to cement its credibility in the face of further months of above target inflation.

It’s also very interesting  just how quickly sentiment has changed between the Euro and Dollar.

The huge Eurozone bailout package did not cure the Eurozone sovereign debt problems and probably just kicked the can further down the road but it did release the pressure value.

It seems though, that the lack of US news has driven everyone Eurozone crazy.

The spread between Irish bond yields and their German counterpart hit an 11 year high as yet another rumour of Irish restructuring of its debt swirled around the market and comments from the Irish Central Bank Governor that the agency set up to buy toxic assets from troubled Irish lenders has not been as successful as he would have hoped.

The Euro has responded, falling against the Dollar and Pound and will probably remain under pressure until the end of the week.

As Wise Money expected the Bank of England’s release yesterday of the MPC minutes revealled that there was a three way split amongst it’s members.
Adam Posen showed that he argued for, and also voted for, an increase of £50 billion in the amount of QE in the system.

This kind of addition would equal a 25% increase in the holding of gilts by the BoE – a sizeable sum.

Naturally, the vote for no change outweighed Posen’s submission and also Andrew Sentence’s regular demand for a withdrawal of liquidity on perceived inflationary pressures.

Sterling didn’t react too well to the outcome – nothing serious but just looked a little vulnerable.

The Budget cut provided little additional information – lots of numbers and political jargon but nothing unexpected for the money markets to react to.

The more prevalent remarks came from the Institute of Fiscal Studies within a report released overnight.

In it they questioned whether the Government’s UK growth projections were overly optimistic and that there was a possibility that the £ 80 billion – odd of cuts might not prove to be enough.

Sterling reacted badly to this forecast, and fell to a 6-month low against the Euro.

Overseas investors are going to need verification that the behaviour taken would produce results before they get their assurance in the currency back. This will leave Sterling prone to continued downside pressure in the short term.

For global currencies, and ahead of this weekend’s G20 meeting in South Korea, two events have provide this morning’s interest. An interview with the US Treasury Secretary, Tim Geithner, reported in today’s Wall St Journal proved interesting reading.

He emphasised that the US had not embarked upon a policy of devaluing the US Dollar and that the strong dollar was still vital for global stability and recovery and that the major currencies values were roughly in line.

He did however divide countries into 3 groups and pointedly entitled the first, which included China, as those whose currencies were “undervalued by any measure”.

He berated the emerging market countries for not allowing market forces to set currency values (especially China) and stated that they all had a role to play.

He added that, “If China knew that if it moved more rapidly, other emerging markets would move with them, it would be easier for them to move.” This could all make G20 a bit lively with the US seemingly trying to create a them and us situation with the us being the ‘good guys’ and the them being cast as the villains.

Sterling may have a volatile day as the Pound gets pushed around by the release of the MPC minutes from the last meeting and the long awaited public spending review, which will be presented by Chancellor George Osborne at lunch time. Right on cue, the former has just been released, showing a MPC member (surprise surprise it was Adam Posen) was the only pushing for further stimulus measures (extra QE) and sending Sterling down 30 pips in quick time.

We finally have 3 different views on the committee, 7 voted for no change and Andrew Sentence again voted for a rate rise. We’ve also just seen worse than forecast public finance and public sector net borrowing data no doubt adding to the negative Sterling sentiment.

The Public Spending Review will detail where the axe will fall, right across government departments.

If there are no surprises and the cuts are in line with the plans announced in the Budget, then most of details should already be priced into the market.

However, we are not ruling out a bolt from the blue by Mr Osborne, as this is why the market will be very choppy right for the majority of today.

The surprise interest rate increase by the Chinese helped the safe haven Dollar to gain slightly across the board.

The move can be seen as part of the Chinese government efforts in unwinding the stimulus measures put in place during the financial crisis and also can be seen in the context of the on going ‘currency wars’ as a olive branch to the US.

Eventually the rate rise should see further appreciation of the Yuan against the Dollar.

The newest member of the Bank of England’s interest rate setting Monetary Policy Committee hit the headlines this morning.Britain faces “significant” risk of a fresh slump into recession according to Dr Martin Weale, who said it would be “foolish” to rule out the possibility of a double-dip downturn. He also thought the Banks central outlook on growth could be too optimistic in light of the fiscal cuts currently being implemented.

The BoE forecast is for growth of about 2.8% in 2011 and 3.2% in 2012. Sterling has dropped over a cent against the dollar following the news and has traded as low as 1.5371.

M&A activity in the US, helped lift sentiment yesterday, unfortunately this did not last for long and both main stock indexes closed marginally down on the day.

There is little economic news again today so focus is likely to remain on the existing home sales in the US which is out this afternoon at 15:00. Figures are expected to show that sales of existing US homes fell to an annual rate of 4.67million in July from 5.37 million in June.

The Bank of England has kept its economic stimulus programme and record low interest rate of 0.5pc in place yesterday amid lingering doubts among rate setters over a sustained recovery for the fragile UK economy.The nine strong Monetary Policy Committee (MPC) was not swayed by the UK economy’s rapid 1.1pc advance between April and June, with growth expected to fade in the second half of 2010 as the biggest Budget cuts since the Second World War take hold.

Mervyn King, the Governor of the Bank of England, has repeatedly emphasised that there is no guarantee that the recovery which began in the fourth quarter of 2009 is sustainable.

The MPC held rates at the historic low of 0.5pc – where they have been since March 2009 –and maintained its target for bond holdings at £200bn, when it announced its monthly decision at noon.

The MPC maintained the ultra loose policy stance it established when the crisis took hold, despite a return to economic growth and a persistent failure to meet its 2pc inflation target.

The consumer prices index – the official measure of inflation – has been above 3pc since the beginning of the year. The Bank is expected to raise its inflation forecasts when it publishes the August Inflation Report next week, to reflect above-target inflation for most of 2011.

Mr King has stated that a failure of banks to lend, as well as weakness in Britain’s key export markets, could hamper growth in the UK.

Fears that Britain’s recovery will slow were reinforced by a snapshot of the UK services sector in July on Wednesday.

Economists had expected a slight improvement to 54.5, and the disappointing news for the economy helped to drive sterling pound down almost a cent lower against the dollar, to close at $1.5877.

The UK’s Consumer Price Inflation rose by 3.2% year on year in June 2010 compared to 3.4% in May, more than the 3.1% average forecast by analysts.

The widely used Retail Price Inflation decelerated to 5.0% in June compared to 5.1% in May. RPI-X also slowed from 5.1% in May to 5.0% in June. However, core inflation accelerated from 2.9% in May to 3.1% in June, which matched the highest reading since 1997.

According to the Office for National Statistics, the biggest downward pressure to CPI inflation between May and June came from falling energy (petrol and diesel) prices. Another significant downward contribution came from clothing and footwear, where prices fell due to the June sales season.

The latest inflation data will boost the case by Andrew Sentance who is the sole member of the MPC who is looking for a gradual interest rate rise and said the path to economic recovery could be uneven but that did not equate to a risk of a double-dip recession. “I favour a gradual rise in Bank Rate which would be aimed to avoid destabilising confidence through a sudden lurch in policy.”

Sterling reacted well against the US Dollar and moved up to above the 1.52 levels at the close of play from opening at 1.4996.

In European news yesterday, the rating agency Moody’s downgraded Portugal’s debt rating by two notches to A1 from its previous AA2 rating, with a stable outlook. Moody’s explained the downgrade with the ongoing deterioration in the debt ratio as well as the dim medium-term growth outlook.

Markets showed little reaction to the news, probably because Moody’s initially placed Portugal on credit watch in May 2010.

The euro held steady against the dollar after a smooth Greek Treasury bill auction eased some concerns about Europe’s debt crisis, this helped take the sting out of Portugal’s expected credit rating downgrade and disappointing German Zew index.