UK traders were largely surprised to see todays Bank of England minutes show two dissenting votes against a rate hike, sparking swift declines in bond...

... yields and the British Pound.


Initial reactions proved premature, however, as a closer examination
of official commentary implied a more mixed outlook on interest rates. Indeed, BoE
Minutes were a far cry from the hawkish rhetoric that Pound bulls had hoped for, but
cautiously crafted statements emphasized that inflationary risks remained to the
upside. As such, we saw initial Pound declines immediately reverse course, with UK
Gilt Futures posting nearly identical moves. The only exception to volatile price
moves was the FTSE 100 Equity Index, which shrugged off the release and remained
unchanged following the news. It will subsequently be important to see how interest
rate futures react to upcoming economic data. Given the mixed emotions evident in
the BoE minutes, subsequent economic releases will likely carry sizeable influence
over interest rate expectations and, by extension, the British Pound.

Bonds - UK 10-year Gilt Futures

Futures traders immediately sent bond yields lower after todays BoE minutes
showed a second voter dissented against raising interest rates by 25 basis points.
Were the unexpected 7-2 vote not enough to cut interest rate hike expectations, the
second dissenter was none other than Deputy Governor Rachel Lomax—a previously
hawkish member of the voting committee. Regardless, it remained clear that knee-jerk
reactions proved slightly exaggerated, with bond futures immediately dropping
initial gains to match overnight lows.
More importantly, Gilts stayed almost exactly unchanged over the day of trading
despite a sharp currency appreciation. Clearly, currency traders were not reacting
to expectations of future interest rate hikes, as Euro-sterling futures remained
nearly flat through the session. As a result, recent Pound strength may run into
considerable resistance if yields do not follow suit. We shall monitor subsequent
price action to measure the likelihood of a retrace or continuation in Gilt and
Pound markets, with bond yields likely to affect the domestic currency near 17-month
highs.


FX - GBP/USD

Currency traders responded to todays minutes in the same way both the equity and
bonds market had. When the release initially hit the tape, the GBPUSD dropped 20
points in the following five minutes. The initial decline came in response to new
dovish comments that had worked their way into the minutes. From the report, Deputy
Governor Rachel Lomaxs neutral dissent sent a shock to the market. A time-tested
hawk, Lomaxs decision to not join the majority in a rate hike led traders to
believe their interpretation of recent inflation reports was out of line with the
MPS view. Furthermore, suggestions that the policy group would be more data
dependant going forward harkened to remarks are now synonymous with the Federal
Reserve, which has passed over rate hikes since July. However, the bearish
conviction of the currency market could keep hold for long. It only took a few
minutes for traders strengthen their convictions and asses what the futures market
was telling them. Futures linked to short-term Libor rates are pricing in another
rate hike before the half-way point of 2007. Furthermore, the fundamental
groundwork for such a shift is already in place. Though the consumer price index
has backed off its recent 2.5 percent highs, the gauge remains well above the
BoEs target 2.0 percent. More importantly, the lofty levels of the RPI provide a
stark reminder that wage negotiations beginning in January will likely yield greater
inflation at the factory and consumer level as consumer spending encourages prices
skyward. When the bullish pace was set in the pound, the GPBUSD proceeded to rally
nearly 150 points, bring spot right up to major resistance.

Equities - FTSE 100 Equity Index Futures

The initial reaction in the equities markets to the minutes was one of confusion.
Since the report printed before the official open of Londons capital markets,
traders were relegated to the futures market for a play on the fundamental action.
The immediate reaction was rather tepid with bids entering on the surprise
dovishness of perpetual hawk Rachel Lomax to push the FTSE futures up to 6,248.
This high was lower than the 8:15 high set just after the open of trade at 6,249 and
helped to set the pace for the rest of the session. When the market began to break
the report into its necessary parts, the modest tinge of dovishness could not
overpower the repeated warnings of inflation risk. With wage negotiations less than
two months away, expectations run high for British consumers to receive a hefty
boost in incomes which will in turn stoke spending. When concerns that another rate
hike could be in the works before the close of the first quarter, the market finally
succumbed to the building pressure behind a technical retracement. Triggered around
11:15 GMT, FTSE futures proceeded to drop 86.5 points from the previous swing high.
The contract closed the session at 6,177.0


Regards,

John Kicklighter
Forex Capital Markets
32 Old Slip, 10th Fl
New York, NY 10005
Email: jkicklighter@dailyfx.com

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