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The “Carney” effect

  Sunday 3rd March 2013

The anticipated arrival of the next Governor of the Bank of England (BoE), Mark Carney, has peaked hedge funds’ interest in sterling and its future position as well as its prospects in the global currency markets.

Sterling has been targeted as the next big mover in the global currency markets. Photo: Sean Kilpatrick

Many top global hedge funds, such as Soros Fund Management, Tudor Investment Corporation, Caxton Associates and Moore Capital, which seek to stabilise future uncertainties for their clients, are now anticipating that the pound could well be in for a future of high exchange volatility and a rapid fall in purchasing power in coming years.

The leading rationale for such expectations is the passing of the governance of the BoE from Mervyn King, current governor, to Mark Carney, former Goldman Sachs banker and current governor of the Bank of Canada, who is due to arrive in his new office in the BoE in July of this year.

As Rob Kaplan, chief investment officer of the largest investor in hedge funds, Permal, has said: “[Hedge funds] are now looking very closely at what they can do with sterling…with Carney coming in, there are interesting opportunities [in] shorting sterling or going long on the [anticipated] volatility of sterling.”

Carney, unknown outside of central banking and financial regulation circles, has a tough but clear reputation for keeping interest rates low and fuelling credit expansion where he feels needed in an aggressive stance to boost economic recovery. The effect of this would be to induce higher inflation within the UK and make UK exports cheaper in the international market.

Carney has been noted as stating: “In my view, flexible inflation targeting – as practised in both Canada and the UK – has proven itself to be the most effective monetary policy framework implemented thus far.”

This by itself has been enough for those involved in the financial sector to read Carney’s back catalogue and digest his views in anticipation of his arrival.

Carney’s position contradicts King’s view of increasing interest rates and tightening expansion when inflation in prices needs to be dampened. King, responsible for the inflation targeting mechanism the BoE works under, had persistently kept inflation at 2% per year. This target has, however, continually been overshot over the past few years in attempt to kick-start the economy with higher access to credit.

The effect of this can be directly seen in the fact that since January 2012 sterling has fell against the euro from 1.275 euros to just 1.150 euros to the pound in January this year – a 9.8% fall. This is because as  inflation has depreciated the purchasing power of sterling against other international currencies, imports have become relatively more expensive and exports relatively less expensive.

Mr. King believes it is safe to relax the inflation target because inflation expectations are well-anchored, partly reflecting the credibility the BoE has built up over 20 years and partly reflecting the very low levels of wage inflation due to the continuing slack in the economy.

Increasingly in the UK “inflation targeting” has turned into “flexible inflation targeting” and the 2% inflation rate is being abandoned.

The intriguing aspect of this is that currently at the targeted and respected inflation rate the BoE receives a lot of faith and confidence from the market that it has a stable grasp on monetary matters. But increasingly by overshooting the inflation rate and the expected adjusting of its target upwards with the imminent arrival of Carney the BoE is beginning to lose its credibility and the market is responding.

Presently investors expect the inflation to rise to 3.2% according to the benchmark “break-even rate” used to signal such expectations – the difference between conventional and inflation adjusted short-term bonds.

Even Carney himself said: “In my view, moving opportunistically to a higher inflation target would risk de-anchoring inflation expectations and destroying the hard-won gains that have come from the entrenchment of price stability”.

Those interested in the stability of the currency and its cost structures are watching the pound’s purchasing power closely in an attempt to play down any changes through taking positions and hedging the movement.

Since the news on the governor change was released and digested, sterling has become the most shorted – meaning sterling is borrowed and paid back after the fall to lock a profit – in the world after the Yen, according to the Financial Times.

Mike Amey, Head of Sterling Portfolio at Pimco, has said in regard to Carney’s five year term: “Carney will probably start forward guidance and try to change the [inflation] target to a 1-3 per cent band. But he will do it gradually.”

Patrick Corby

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