What Are The Markets Facing?

The Bank of England is expected to leave rates unchanged at Thursday’s monetary policy meeting, as inflation continues to rise on increasing fuel and food costs. Governor King stated that in the central bank’s quarterly inflation report that he expects to have to write letters of explanations to the government for several quarters as that is required when inflation breaches the 3% threshold, where it currently sits. The MPC was extremely dovish at its last policy meeting where only ardent dove David Blanchflower voted to cut rates, which led to expectations that rate would be left unchanged for the remainder of the year. However, the recent earnings warning of the U.K.’s largest mortgage lender Bradford and Bingley, mortgage approvals hitting a nine year low and the continuation of falling house prices have reignited recession fears. Additionally, the service and construction sectors contracted in May and manufacturing sit on the brink with a reading of 50, according to the PMI measurements. Britons have become to succumb to the headwinds from the housing slump and credit crisis as GfK consumer confidence fell to -29- the lowest since 2004, and retail sales unexpectedly declined 0.2% in April. The central bank doesn’t customarily issue a statement with a rate hold. However, giving the current environment of declining fundamentals and continued fall out from the subprime crisis, some remarks may be forthcoming.

Bonds – Long Gilt Futures

Gilts have started to consolidate as risk aversion has returned to the market after U.K.’s top mortgage lender Bradford & Bingley’s issued a profit warning. Also, U.S. investment bank Lehman Brothers is in the process of securing additional financing which has led to speculation that several banks may not have enough reserves to cover future losses resulting from the subprime crisis. Additionally, declining U.K. fundamentals have reduced the chances the BoE can go the entire year without a rate cut which has been the recent consensus. A hawkish central bank has weighed on bonds and if the MPC maintains that bias then the contract may fall to test support at 104.90. Conversely, if governor King provides a statement following a rate hold with concerns of mounting downside risks a bond rally could follow.

FX – GBP/USD

The GBP/USD pair started the week gaping down on the Bradford & Bingley profit warning and was weighed further by bullish dollar comments from Fed Chairman Ben Bernanke and weakening U.K. fundamentals. The country saw manufacturing, construction and services all decline to or near contraction. Consumer confidence falling to its lowest level since 2004, due to Britons getting squeezed by rising inflation and declining home values, led to the latest dip lower. The pair was threatening to break from its downtrending channel on a hawkish BoE and the upside risks of inflation before being derailed by the dour financial and fundamental news. Beware the current dip may be a trap as reported in Jamie Saettele technical report, where he is calling for a pound rally with a 1.9850 target against 1.9362. Indeed, a rate hold and a bullish BoE may be the catalyst for that potential rally. However, a dovish central bank and further fallout in the financial sector may see the pair break below support with significant downside risk remaining.

Equities – FTSE 100 Index

The FTSE 100 fell on the Bradford & Bingley’s profit warning as it weighed the whole banking sector lower. Outside of the mining sector prospects for the rest of the index have been dimming with consumer confidence and consumption falling and the housing sector failing to bottom. The implications of rising inflation on future domestic spending, corporate margins and the chances of a rate cut have weighed stocks lower. The FTSE has been on a steady decline since the minutes from the BoE last meeting revealed that the MPC may not cut rates until next year. Equities have fallen below the 200 Day SMA and have found support at the 100 Day SMA. However, another hold by the central bank and the absence of any statements indicating that the committee has changed their bias may see the index look to test resistance at 5820.

Terri Belkas is a Currency Strategist at FXCM.