How to Trade the Bank of England Interest Rate Decision

The Bank of England is widely expected to hold the benchmark interest rate steady at the record-low of 0.50% in an effort to steer the economy out of a deepening recession, and may reinforce its opposition for another stimulus package even as the downturn in the global economy intensifies.

Impact of the Bank of England Rate Decision on GBP/USD Over the Last Two Quarters

March 2009 Bank of England Rate Decision

The Bank of England voted unanimously to slash the benchmark interest rate by another 50bp to a record-low of 0.50%, and pledged to purchase as much as GBP75 billion of government and corporate debt in an effort to steer the economy out of a deepening recession. Moreover, BoE governor Mervyn King said that the interest rate in the UK is "very unlikely" to fall lower from its current level as the board adopts quantitative easing to stimulate the ailing economy, and went onto say that "the inflation target provides a natural guide" for monetary policy going forward. Nevertheless, as the BoE concludes its easing cycle, long-term expectations for higher rates could boost demands for the British pound over the near-term, however, as the economic docket continues to reinforce a dour outlook for growth and inflation, fundamental headwinds are likely to weigh on the exchange rate as the economic downturn in the region intensifies.

February 2009 Bank of England Rate Decision

BoE governor Mervyn King and company lowered the key interest rate by 50bp to 1.00%, which is the lowest level since the central bank was founded in 1694, to overcome David Blanchflower's plea for a 100bp rate. Meanwhile, the central bank stated that the MPC "Would need to use alternative policy measures" to stimulate the economy as the interest rate falls close to zero, and is likely to adopt quantitative easing over the near term in order to manage monetary policy going forward. As the outlook for growth and inflation deteriorate, the BoE is expected to take unprecedented measures to shore up the economy, however, as Mr. Blanchflower expects the economic downturn to worsen "significantly" during the year, the comments certainly underscore the dire state of the economy, and conditions are likely to get worse as turmoil in the banking sector intensifies.

What to Look for Before the Release

MoneyShow.com readers who also have 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 GBP/USD 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 GBP/USD ahead of the data release.

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The Bank of England is widely expected to hold the benchmark interest rate steady at the record-low of 0.50% in an effort to steer the economy out of a deepening recession, and may reinforce its opposition for another stimulus package even as the downturn in the global economy intensifies. The final 4Q GDP reading for the UK showed that the economy contracted at an even faster pace from the preliminary release, as private consumption, which is one of the biggest drivers of growth, dropped 1.0% from the third quarter, and as the central bank expects 1Q GDP to contract at levels much like what we've seen in the fourth quarter, policymakers may take further steps to shore up the economy as the outlook for growth and inflation falters. Earlier this week, the Chancellor of the Exchequer, Alistair Darling, admitted that the HM Treasury has underestimated the depth and severity of the financial crisis during an interview with the Sunday Times, and went on to say that he does not expect the economy to recover until the end of the year. As a result, Mr. Darling is widely expected to cut the government's growth forecasts later this month, and may push for additional spending as Prime Minister Gordon Brown pledges to do "whatever it takes" to get the economy back on track. The comments suggests that Mr. Brown, along with the Treasury, are considering taking further steps to jump start the economy, however, BoE governor Mervyn King has sternly opposed driving up government spending from its current level as the European Union forecasts the UK's budget deficit to reach 9.6% of GDP by March 2019, which is nearly three times higher than the EU's limit. Mr. King stated that "It would be sensible to be cautious" as the surge in public finances poses a threat to long-term stability, and went on say that the government should take "target and selected measures" as it sees fit. Meanwhile, the debt management office failed to auction government bonds for the first time in 14 years following the comments from the central bank head as investors grew skeptical of the central bank's quantitative easing approach aimed to stabilize the banking sector, and as the BoE sails into uncharted territory, mounting uncertainties surround the outlook for future policy and could weigh on the exchange rate as the economy faces a deepening recession.

Trading the given event risk may not be as clear cut as some of our previous trades, but nevertheless, as the Bank of England pledges to hold borrowing costs at the record low and raise the money supply by nearly GBP75 billion over the next three months in an effort to soften the landing of the economy, long-term expectations for higher interest rates paired with an improved outlook for inflation would set the stage for long pound trade. Therefore, if the central bank states that the interest rate has reached a bottom, and sees lower risk for deflation, we will look for a green, five-minute candle following the release to confirm a buy entry on two lots of GBP/USD. Once these conditions are met, we will set our initial stop at the nearby swing low (or reasonable distance taking volatility into account), and this risk will determine our first target. Our second target will be based on discretion, and we will move the stop on the second lot to break even once the first trade reaches its target in order to preserve our profits.

On the other hand, as the downturn in the global economy intensifies, the BoE may continue to reinforce a dour outlook for growth and inflation, and may signal that it may need the remaining GBP75 billion from its asset purchase program as the region faces its worst recession in over half a century. As a result, if the central bank foreshadows a weakening outlook for price growth, and indicates that the board may discuss further ways to shore up the economy, we will look to sell the British pound, and will follow the same strategy for a short GBP/USD trade as the long position mentioned above, just in reverse.

Inflation Outlook Improves-Stronger Than Expectations

Increasing Risks for Deflation-Lower Than Expectations

By David Song, Currency Analyst, DailyFX.com