A Tale of Policy Shifts as the UK goes QE2

BBH CurrencyView

• Sterling plummets as BoE surprises the market with QE announcement; global stocks, oil advance
• All eyes turn to Berlin for Trichet’s last meeting in the hopes of a policy announcement
• BoE announcement see QE larger and earlier than many expected; Swiss inflation increases

A better risk backdrop driven by the hopes of policy response from the ECB after the BoE announced additional QE of £75bln and a European bank recapitalization scheme continue to underpin stocks and growth sensitive currencies. The BoE cited strains in the bank funding market as key catalyst for the move, with the surprise move prompting sterling to plummet nearly 1.2% following the announcement. At the same time, EU Commission President Barroso said today that the commission will propose coordinated action to recapitalize banks and there are reports of a fresh round of stress tests. As a result, European stocks continue to advance with the EuroStoxx 600 up nearly 2% led in part by a 3.5% rise in banking shares. S&P 500 index futures, meanwhile, are showing a 0.7% gain in overnight trade, pointing to another strong Wall Street open for the cash index. Asian equities have extended gains, with the MSCI Asia Pacific index advancing 3.3%, led by the tech sector despite news of the passing of Apple founder Steve Jobs at the age of 56, which was countered somewhat by speculation of a merger between two large technology firms.

All eyes lead to Berlin this morning, where the ECB meets and Trichet gives his final ECB press conference. There is much speculation that the ECB is likely to provide some form of accommodative policy, given the speed at which the euro zone economy has decelerated in the recent months and how inflation is expected to fall as a result. The OIS market appears convinced that the ECB will cut by at least 50bps today, with the market implying nearly a 100% chance of a 25bps cut. Admittedly, at some point we expect the ECB to cut rates but given last week’s rise in inflation and the M3 money supply we suspect the ECB is more likely to offer other forms of monetary easing. The ECB’s critics worry that the central bank is blurring fiscal and monetary policy, but the ECB itself draws a clear distinction between liquidity measures and monetary policy proper. The ECB’s focus is likely on liquidity measures. As such, this is likely to include another 6-month refi and re-introduction of a 12-month facility, extension of bond buying to include “covered” bonds and reinforcing the sense that the ECB is ready and willing to buy bonds to stabilize Europe’s banks are at this juncture all options that are arguably more important and more likely than a rate cut. Nevertheless, it is likely that if we do not see the ECB cut rates that Trichet may provide hints at the press conference that the ECB will next month. This would most likely give the ECB increased political leverage as Draghi, the first ECB president from a peripheral country, takes on the leadership role next month. For the euro, we think the best outcome would entail “the kitchen sink option” where the ECB uses both conventional and unconventional measures to address the financial stress in the banking sector. Normally, more accommodative monetary policy is associated with currency weakness amid the contraction in relative interest rate spreads but in the near-term we think the euro would actually respond positively to accommodative policy as it may be associated with boosting risk appetite. Alternatively, if the ECB disappoints and its leaves policy unchanged we suspect the euro is likely to remain under pressure.

The BoE hit the QE button early, by announcing a £75bln program ahead of the ECB meeting in Berlin. And while there was a possibility of the BoE announcing a new QE the program this morning the market was nevertheless surprised by the size and timing as many observers had expected the BoE would deliver in only £50bln November. As such, we expect sterling to remain under pressure given the last round of QE led sterling to decline between 4-6% against the dollar. Elsewhere in the G10 Swiss September CPI came in above expectations at 0.5%, up from 0.2% in August. The SNB may take some satisfaction from the rise in inflation as the threat of deflation was one of the central reasons for pegging the CHF, though the rise seems to reflect a change in method. Indeed, safe-haven driven currency strength had been one of the main causes of disinflation in the Swiss economy. The increase in consumer inflation was primarily due to the end of the sales on clothes and the introduction of more expensive winter clothes, which saw the clothes component rise 8.7% m/m, while there was a 3.4% m/m price rise for crude oil products. The SNB is likely to maintain an expansionary policy for now and as a result many observers suspect the SNB is expected raise the lower limit of the EUR/CHF. Indeed, the EUR/CHF has just pushed through its 200 day moving average with many option strikes seen at 1.25.