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It’s the economic data pound traders have been waiting for all month.
Friday’s Purchasing Managers’ Indexes for the U.K. have been touted as potential game changers for the Bank of England’s interest-rate decision next week, which could set the direction for both sterling and gilts. Investors are braced for swings in the U.K. currency, with one week-implied volatility rising on Thursday by the most since early December.
Traders across Europe are facing a busy morning. PMIs for France, Germany and the euro area will influence policy outlook there and may set the tone for bunds and the euro. The euro held losses after French PMI data painted a mixed picture, before rising on a pickup in German activity and business confidence.
Money markets are pricing in around a 53% chance of a BOE reduction on Jan. 30, the day before Britain is due to exit the European Union. Yet the odds have whipsawed as dovish comments from policy makers and weak data compete against optimism among manufacturers and strength in the jobs market. This has made the latest U.K. data, which are forward looking, particularly important to the markets.
Goldman Sachs International believes the BOE decision will be “heavily influenced” by Friday’s numbers, strategists including Adrian Paul said in a client note last week. The PMIs come with the pound in “wait and see mode” according to Jordan Rochester, a foreign exchange strategist at Nomura International Plc in London.
Clients, brokers and economists see a reading of 52 as potentially stopping the BOE from cutting rates, he said. “A level higher than that would be a large, market-moving event, especially for front-end BOE pricing.”
One-week risk reversals on Thursday showed the most bullish sentiment on sterling in nearly two months -- a sign traders feel the market may have over priced a rate cut. Economists surveyed by Bloomberg see the composite PMI coming in at 50.7, compared with 49.3 previously.
The U.K. currency has been beholden to speculation about the BOE since outgoing Governor Mark Carney said earlier this month that there was room to expand quantitative easing. The currency has also been weighed down by dovish comments from Carney’s colleagues and weak economic data but pushed up by growing signs of a post-election recovery.
Gilts surged amid a global rally for haven assets on Thursday, on concern across global markets about the implications of a SARS-like virus in China. Benchmark U.K. yields hit their lowest level since October.
What Bloomberg Intelligence Says
“Markets will be focused on the data with nothing significant out of the European Central Bank. Virus fears are spreading across markets. The PMIs have potential to see bonds unwind some of the flight-to-quality virus bid. It is worth considering downside bund options for now, which may payoff with a data bounce and spillover from U.K. PMIs beating expectations, while not being fully exposed to the virus.”
-- Tanvir Sandhu, Chief Global Derivatives Strategist
Big Bounce Needed
Danske Bank A/S analyst Mikael Olai Milhoj has been forecasting a January rate cut since November. The Copenhagen-based strategist says higher demand for gilts may have supported sterling, though he is surprised the pound did not drop lower on expectations of monetary easing.
“We need to see PMI composite at least above 51.5 for me to change my call,” he said. “If the BOE cuts later this month, we could see a weaker pound as investors will likely price in a slightly higher chance of a second rate cut. But given this would be unlikely until the second half of the year, I think markets will move on to focusing on something else.”
Deutsche Bank’s base-case is also for the PMI readings to cement the chances of a rate cut. The bank expects a bounce in the data, with the composite PMI reaching 51.1, but not one large enough to convince policy makers to hold rates steady.
The composite reading will need to“break out of its H2-2018/2019 level” as well as “showing that the economy is trending back towards potential,” said Sanjay Raja, the bank’s U.K. economist. “This would be consistent with a reading closer to 52.5.”
Looking beyond the flash reading, the devil may be in the detail, says Nomura’s Rochester. “If it’s not a broad recovery, such as new orders/new business not rising much and output remaining weak, then it could still see the BOE cut,” he said.
(Updates pricing, adds French, German PMI data in third paragraph.)
--With assistance from Vassilis Karamanis and David Goodman.
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