GBP/USD: Trading the Bank of England Interest Rate Decision

Trading the News: Bank of England Interest Rate Decision

Why Is This Event Important:

Uncertainties surrounding the Bank of England interest rate decision are likely to keep the GBP/USD range-bound in the days ahead, but comments from the central bank would spark increased volatility in exchange rate as investors weigh the prospects for future policy. However, if the central bank refrains from releasing a policy statement like we’ve seen during the past few months, muted price action would push us to the sidelines as the MPC is scheduled to release the meeting minutes on October 20th.

What’s Expected:

Time of release:10/07/2010 11:00 GMT, 7:00 EST

Primary Pair Impact :GBPUSD

Expected: 200B

Previous: 200B

Will This Be Market Moving (Scenarios):

A Bloomberg News survey shows 35 of the 36 economists polled forecast the BoE to hold the benchmark interest rate at 0.50% and maintain its asset purchase target at GBP 200B later this week, while investors are pricing a four percent chance for a 25bp rate hike according to Credit Suisse overnight index swaps. At the same time, we expect MPC board member Andrew Sentance push for another rate hike this month as price growth continues to hold above the government’s 3% for inflation, but a three-way split could spark a bearish breakout in the GBP/USD as price action trades within the narrow range carried over from the previous week.

The Upside

The headline reading for U.K. inflation unexpectedly held steady at 3.1% for the second consecutive month in August, while the final 2Q GDP report showed economic activity expanded 1.2% from the first three-months of the year to mark the fastest pace of growth since 2001. As the recovery slowly gathers pace, members of the MPC may support Mr. Sentance’s call to gradually normalize monetary policy, and the central bank may drop its dovish tone given the stickiness in price growth.

The Downside

The International Monetary Fund lowered its growth forecast for Britain and sees economic activity expanding 2.0% in 2011 versus an initial projection for a 2.1% in the growth rate. The group went onto say that the BoE should expand monetary policy further if the recovery falters, and expects inflation to fall back towards the 2% target going into 2012 given the substantial amount of slack within the real economy. As the outlook for growth and inflation deteriorates, there could be a three-way split within the MPC as policy makers vote to expand quantitative easing.

How To Trade This Event Risk

Trading the given event risk is certainly not as clear cut as some of our previous trades, but a two-way split within the BoE could set the stage for a long British Pound trade as Mr. Sentance continues to push for a 25bp rate hike. Therefore, if the central bank maintains its current policy, with additional members of the MPC voting to increase borrowing costs, we will need a green, five-minute candle following the rate decision to establish a buy entry on two-lots of GBP/USD. Once these conditions are fulfilled, we will set the initial stop at the nearby swing low or a reasonable distance after taking market volatility into account, and this risk will generate our first target. The second objective will be based on discretion, and we will move the stop on the second lot to cost once the first trade reaches its mark in order to preserve our profits.

In contrast, the ongoing stack within the real economy paired with fears surrounding the growth outlook may lead to a three-way split within the MPC, and speculation for further easing could spark a bearish reaction in the sterling as investors weigh the prospects for future policy. As a result, if votes for an expansion in QE materialize, we will look to utilize the same strategy for a short pound-dollar trade as the long position laid out above, just in reverse.

Potential Price Targets For The Rate Decision

Impact Bank of England rate decision has had on GBP during the last meeting

September 2010 Bank of England Interest Rate Decision

The Bank of England voted 8-1 to hold the benchmark interest rate at 0.50% and maintained its asset purchase target at GBP 200B, while board member Andrew Sentance made another push to raise borrowing costs by 25bp. The central bank reiterated that it stands ready to move monetary policy in either direction as the economic outlook remains clouded with uncertainties, while some members saw scope to expand quantitative easing further as they expect the recovery to taper off throughout the second-half of the year. The BoE went onto say that the risks for inflation have not changed “materially” even though price growth continues to hold above the government’s 3% limit, and argued that the downside risks for growth have increased given the ongoing slack within in the real economy. As policy makers maintain a mixed outlook for the region, we may see a three-way split within in the MPC as they aim to balance the risks for the region.

What To Look For Before The Release

Traders with access to market depth information via the FXCM Active Trader Platform may use it to gauge the potency of the economic data release as well as to shed some light on the market’s directional bias. Increasing volume ahead of the announcement will telegraph likely follow-through behind whatever move is to materialize, while an imbalance in available liquidity on the Bid versus the Offer side of the market will tell us the direction major institutions are likely favoring ahead of the announcement:

Bullish Scenario: If we see substantially deeper available liquidity on the Bid side of the market, this tells us that major price providers in the market are looking to buy the GBP against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bullish bias on GBPUSD ahead of the data release.

Bearish Scenario: If we see substantially deeper available liquidity on the Offer side of the market, this tells us that major price providers in the market are looking to sell the GBP against the US Dollar. Considering that close to 60% of all FX market volume is cleared through just six top banks, we see it prudent to be on the same side of the trade as major institutions and will favor a bearish bias on GBPUSD ahead of the data release.

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To discuss this report contact David Song, Currency Analyst: dsong@fxcm.com