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

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

2010-05-07 20:03:00
David Song, Currency Strategist
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Trading the News: Bank of England Interest Rate Decision

Why Is This Event Important:

As the U.K. faces a hung parliament, market participants will certainly look towards the Bank of England interest rate decision as they weigh the prospects for future policy. The central bank has held a dovish outlook throughout the first-half of 2010 as households continue to face the deterioration in the labor market paired with tightening credit conditions however, the MPC may raise its economic outlook as the European Commission doubles its growth forecast and expects GDP to increase 1.2% this year amid an initial projection to a 0.6% expansion in the growth rate. However, as the government struggles to manage its public finances, the rise in the deficit could bear down on monetary policy and lead the BoE to maintain a loose policy stance going into the second-half of the year as government officials aim to encourage a sustainable recovery.

What’s Expected:

Time of release:        05/10/2010 11:00 GMT, 7:00 EST
Primary Pair Impact :    GBPUSD
Expected:         0.50%
Previous:         0.50%

Will This Be Market Moving (Scenarios):

The Bank of England is widely expected to hold the benchmark interest rate at 0.50% and maintain its asset purchase target at GBP 200B in May as the central bank continues to support the real economy, but the stickiness in consumer prices may lead the governing board to drop its dovish rhetoric as the economic recovery gathers pace. However, the MPC may fail to release a policy statement following the rate decision as we saw in April as it continues to assess the impact of its unprecedented efforts.

The Upside

As consumer prices in the U.K. exceed the central bank’s upper limit for the second time in 2010, the BoE may drop its dovish rhetoric and see scope to normalize policy further later this year as it aims to balance the risks for growth and inflation. As a result, if the MPC terminates its asset purchase facility and sees a threat for higher inflation later this year, market participants may raise speculation for a rate hike later this year, which could lead the British Pound to appreciate against its currency counterparts.

The Downside

At the same time, the ongoing slack in the private-sector may lead Governor Mervyn King to hold a dovish outlook for future policy as he expects inflation to fall below the 2% target later this year. In addition, policy makers have held a cautious tone for the economy as they see a risk for a contraction in GDP, and the BoE may look to defend its loose stance for monetary policy as the recovery remains fragile.

How To Trade This Event Risk

Trading the given event may not be as clear cut as some of our previous trades as the central bank is expected to hold borrowing costs at the record-low and maintain the option to expand its asset purchases over the coming months but nevertheless, a rise in the central bank’s economic assessment could set the stage for a long British Pound trade as the recovery gathers pace. Therefore, if the BoE drops its dovish rhetoric and sees scope to normalize policy further in the second-half of the year, we will need to see a green, five-minute candle following the meeting to establish a buy entry on two-lots of GBP/USD. Once these conditions are met, we will set the initial stop at the nearby swing low or a reasonable distance, 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 an effort to lock-in our profits.

In contrast, fears of a protracted recovery paired with expectations for lower inflation may lead the central bank to hold a loose policy stance going into the second-half of the year as the MPC aims to support the real economy. As a result, if the BoE sees scope to maintain a dovish bias of monetary policy and maintains the option to expand its emergency program over the coming months, we will favor a bearish outlook for Cable, and will utilize the same strategy for a short pound-dollar trade as the long position laid out above, just in reverse.

05.09_TTN1

Impact that the Bank of England Interest Rate Decision has had on GBP during the Last Month

05.09_TTN2

April 2010 Bank of England Interest Rate Decision

The Bank of England voted unanimously to hold the benchmark interest rate at 0.50% and to maintain its asset purchase target at GBP 200B as the central bank aims to encourage a sustainable recovery. However, the minutes of the meeting noted that the “period of above-target inflation” was becoming a concern for some of the members on the MPC, but went onto say that the board agreed that “it was appropriate to maintain the current stimulatory stance” in an effort to support the real economy. At the same time, the central bank said that the rebound in economic activity appears “to have been carried forward into the beginning of 2010,” but continued to see a need for “fiscal consolidation” as the government struggles to manage its public finances. As a result, the central bank may look to maintain a dovish bias going into the second-half of the year as the rise in the deficit puts additional pressures on monetary policy. 05.09_TTN3

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.
00001_GBP 00002_GBP

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To discuss this report contact David Song, Currency Analyst: instructor@dailyfx.com

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