Those who assume that shorting the British pound is a sure bet got a warning on Wednesday: The currency rebounded quickly against the dollar in overnight Asian trade. Like the latest downward journey, this upward move was triggered by U.K. Prime Minister Theresa May.
May said late on Tuesday she was prepared to give lawmakers a "full and transparent" debate on her plans to take the U.K. out of the EU, before Article 50 is triggered. This has reassured investors, up to a point, that the Prime Minister is trying to build consensus, rather than forge ahead with her own ideas on how to proceed. The pound firmed by almost 2% in early trade in Asia.
The British currency is likely to swing wildly in both directions with every such revelation, so short-sellers risk getting caught on the wrong side of the trade. Besides the government, though, currency traders are also watching the Bank of England's every move.
What happened in January 2015 when the Swiss central bank suddenly dropped the Swiss franc's peg to the euro shows why getting up to speed on the various ways national banks treat their currencies is a must for any investor.
Here are five things the Bank of England could do to give a boost to the currency if it feels it weakens too much:
Raise interest rates. This is the most unlikely scenario. The Bank of England cut interest rates in half in August, to a 300-year low of 0.25% and relaunched its quantitative easing program. Within it, the central bank is buying government bonds and corporate bonds to make debt cheaper for companies in the hope they will invest and therefore boost the economy. It is unlikely to give up this goal just to correct a short-term move in the currency.
Another reason why the central bank is likely to refrain from raising interest rates is the housing market. I wrote in a story published on Real Money before the referendum that if the Bank of England is forced to hike rates to avoid high inflation caused by a much weaker pound, it risks crashing the housing market. Many investors have piled into buy-to-let property looking for yield over the past five years, so a housing crash would definitely cause a recession.
Still, if it is confronted with massive depreciation, the Bank of England could move the rate back up. Probably 10 basis points would be enough for traders to get the message.
Expand its purchases of government bonds. U.K. government bonds are another area that has been rocked by investors' jitters. Yields on 10-year U.K. government bonds, also known as gilts, rose close to 1% from 0.3% six months ago as investors are dumping them. In today's context of negative yields on the continent and with the central bank cutting, not hiking rates, that is a big move.
The Bank of England is committed to buying an additional £60 billion ($73 billion) in U.K. government bonds, bringing the total size of its QE effort to £435 billion. This means the central bank owns around 30% of the total U.K. government bonds market, which is £1.46 trillion according to the Debt Management Office. It is not a comfortable position, but the central bank can always buy more if it needs to make up for the foreigners' selling.
Buy pounds direct from the market. This form of currency intervention is used especially by central banks in emerging markets. It has the purpose of "scaring off" speculators and making them drop adverse positions. It can be useful in propping up the currency, but it is a short-term measure. Still, if you are a speculator caught short it's not pleasant, to say the least.
In some emerging markets, the central banks do this by asking traders for firm bid/ask quotes or by making firm offers themselves. Usually the simple signaling of intention is enough, but the central bank will go ahead and buy currency with its foreign exchange reserves if this showing off on traders' screens is not enough.
You may wonder whether the Bank of England's foreign currency reserves are enough for that kind of cat-and-mouse game. Remember that central bankers are all friends, and can swap currencies in times of need.
Intervene indirectly via commercial banks. This is another emerging markets-inspired strategy. What some central banks in developing countries sometimes do is they buy a significant quantity of currency from one, two or a selected few commercial banks. These then have to go to the market to get the amounts they need, putting pressure on the exchange rate.
Again, it is a short-term move, but could be effective in creating the illusion of demand for the country's currency and shaking off the bears. These days it has the advantage that it is difficult for market participants to catch the central bank doing it. Sharp turns in exchange rates could also be caused by algorithms reversing once they reach a certain pre-programmed price.
Resorting to verbal intervention. In words that are now legendary, the central bank could pledge to do "whatever it takes." Mario Draghi's famous promise in 2012 to do whatever it takes to keep the euro together effectively put a floor under the currency and marked a turning point in the eurozone crisis.
It was more efficient than any of the steps I mention above taken together. For this to work, though, the central bank needs to enjoy strong credibility in the market. The Bank of England still commands the markets' attention, so it could pull it off -- on the condition that the government stops attacking it.
Editor's Note: This article was originally published at 8 a.m. EDT on Real Money on Oct. 12.
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