The last three days of trade have seen the pound dropping at an sustainable pace, as traders price in a weaker recovery of the U.K. economy.
The downtrend was started on Thursday, following the Bank of England interest rate decision, where the bank's Monetary Policy Committee decided to surprise the market by expanding, for a second consecutive time, the asset buying program.
The main purpose of the asset buying program is to increase the price of U.K. corporate bonds, commercial paper and gilts (debt instruments issued by the U.K. government), thus reducing the yield and make re-financing cheaper. In addition, the bank intends to boost the money supply in order to drive up nominal spending at a time when production remains flat or decreasing; a move that would spark inflation.
The Bank of England has intimated for some time that it is likely to miss the inflation target of 2%, over the next few quarters, according to the quarterly Inflation Reports. The next Inflation Report is due to be released on Wednesday, and is likely to have a crucial influence over the pound's valuation.
Usually traders use the Inflation Report for two main purposes: to explain the decisions previously taken by the Monetary Policy Committee, and to gauge the bank's expectations regarding inflation and output, on which the BoE's monetary policy decisions are taken. Most market participants expect the inflation report to show a stronger output from 2010 (which currently is slightly above 1%).
Another view is that the Inflation Report is likely to show a downward shift in the inflation projections, which according to TheLFB-Forex.com Trade Team, was the main cause behind the decision to increase the size of the asset buying program, announced last week.
To put the asset buying program to work, the bank has at its disposal £175 billion, or roughly 30% of the entire gilt market. This is a massive amount of government debt to finance, which is reflected in the pound's reducing value, as the BoE is printing money that yields 0.25%. In reality the Bank is producing money that is as close to being free as most have ever seen.
In the short-term, the currency market will focus on the reasons why the BoE decided to increase the size of the asset buying program, at a time when the market expected the program to be shut down, since the global economy is seen to be on the recovery path. If the BoE adds to the printing press assault, and downgrades its growth forecast, the pound will probably see some strong, institutional sized, sell orders.
A similar short-pound reaction will happen if the BoE hints that the size of the asset buying program will be expanded again in the future. This would probably happen if the updated inflation projections suffer a large decrease from the one released in May. The Inflation Report gets in under the radar of most forex traders, and this is notice being posted that to ignore the August report is sheer folly. This is as pivotal a time for U.K. economics as has been seen since the 2007 inception of the sub-prime crisis, and could dwarf the credit crisis reaction if the U.K. reveals weakness at a time that the global economy is looking for stories of strength.
The U.K. is a serviced based economy, that is also on of the larger global exporters, and as such will be content with a reduced Gbp valuation against the Eur, Chf, Jpy, and Usd. The fact that the U.K., and U.S. are the larger owners of each other's government debt will also have a bearing on Wednesday's report, as the battle for fair value on yields and currency rates takes place.
Could the U.K. be the first region to openly admit that forward GDP-to-Debt ratios are further out of line than most would have thought to imagine?
If so, the Emperor's New Clothes revelation may have huge currency value ramifications, for other regions that are hiding massive debt-to-growth issues, behind what they think is a veil of secrecy. The U.K. is certainly not in any way a global economic outcast; moreover it is in some regards a bastion that links the global trading world. For the U.K. to reveal a massive weakness in what the Bank of England perceived as potential growth, and for them to be so far off the mark in regard to the depth that the economy dropped into recession, may just force others to reveal their own hands.
The Emperor may well have no clothes on, and Wednesday may be the day that all is revealed, especially as the Federal Open Market Committee release the U.S. rate decision on the same afternoon. Maybe we will see two Emperors' without clothes, and if so, who will be the first to shout it out?