Bagpipes Risk Drowning Out Carney Guidance on Rates: U.K. Credit

Mark Carney has got markets dancing to the tune of his forward guidance on interest rates. He could soon be drowned out by the sound of bagpipes.

Bond and currency traders have been reacting to the Bank of England governor’s every word as they try to divine when the benchmark cost of borrowing might rise for the first time since 2007. They may be paying too little attention to the possibility that voters in Scotland call time on the 307-year-old U.K. in the Sept. 18 referendum, according to David Owen, chief economist at Jefferies International Ltd. in London.

“The elephant in the room as far as monetary policy this year is concerned is the Scottish vote,” said Owen. “Everything would get pushed back because it would impact confidence. Absolutely it would blow a November or December rate rise out of the water.”

Polls consistently show the nationalists trailing behind the campaign to keep the union intact, yet enough people are undecided to cause an upset. Should Scotland vote for independence, the damage to confidence among consumers and businesses may prompt policy makers to delay the tightening of monetary policy, according to Jefferies and BNP Paribas SA.

Investors are “a bit complacent” over the risk of a breakup, according to David Tinsley, an economist at BNP Paribas in London and a former BOE official.

Upfront Effect

He said he may push back his forecast for the Monetary Policy Committee to increase its benchmark rate from a record-low 0.5 percent in November by between one and two quarters in the event of Scottish independence.

“The main effect on the economy would be quite upfront,” Tinsley said. “So if you didn’t see a rate rise in November and there was a ‘Yes’ vote, then probably by the middle of 2015 the MPC would, if the smaller U.K. was looking okay, be prepared to countenance one again.”

Scotland’s 150 billion-pound ($260 billion) economy accounts for about 9 percent of total U.K. gross domestic product, while its 5.3 million people represent just over 8 percent of the population, official data show.

In the past month, traders increased wagers on a 2014 rate increase after Carney said on June 12 that a tightening may come sooner than investors were anticipating. Short-sterling contacts expiring in December yielded 0.86 percent at 10:37 a.m. in London today, up from 0.73 percent on June 11.

The paradox is that Scotland might end up influencing U.K. monetary policy even though Prime Minister David Cameron, backed by the major British political parties, ruled out sharing the pound and central bank with a newly independent state.

Below Target

Owen said policy makers may hold rates through November next year if Scotland votes to leave. With inflation below the BOE’s 2 percent target and slowing, the central bank may even have to loosen policy, reverting to printing money, he said.

“You could imagine a scenario where they’re doing quantitative easing again,” Owen said. “I’m not saying that’s likely, but you can’t rule it out.”

Using his flagship forward-guidance policy, which links the outlook for rates to the amount of spare capacity in the economy, Carney entrenched investor expectations for a rate increase in 2015 at a press conference in May. He shifted perceptions a month later when he said an increase in interest rates “could happen sooner than markets currently expect.”

That prompted investors to bring forward bets on a quarter-point rate increase, with December short-sterling futures rising as high as 0.93 percent on June 16. Investors are betting the BOE will raise its main rate by February, Sonia contracts show.

Bigger Picture

The MPC will start their monthly two-day policy meeting tomorrow and make an announcement at noon on July 10 in London.

Owen said he expects Scots to reject independence, “but it will be relatively close” and investors are not yet fully pricing in the possibility of a breakup. Gilts have returned 3.1 percent this year compared with 2.8 percent for Treasuries. The two-year yield spread has widened to about 38 basis points from 28 since Carney’s Mansion House speech, with the 10-year gap increasing to 12 basis points from 7.

“The gilt market is so focused on the timing of the first rate rise in a sense it’s to some degree missing the far bigger picture,” Owen said. “We might find, running into September, the spread of U.K. gilts over U.S. Treasuries widens out and the currency starts coming under some pressure.”

Pound Discount

The pound may trade at a pre-referendum discount of 0.3 percent to 1 percent on a trade-weighted basis, before weakening as much as 4.3 percent should Scots embrace independence, Barclays Plc analysts said in a May 27 report. Deutsche Bank AG, the world’s second-biggest foreign-exchange trader, recommended clients position themselves for more volatility in the currency before the ballot.

Investors might be kept guessing on the final implications of the breakup as the Scottish and U.K. governments debate constitutional arrangements before formal independence in March 2016, said Tinsley, who also expect voters in Scotland to choose to stay in the U.K.

“I don’t think the economic uncertainty would last as long as that,” said Tinsley. “But there’d be the odd twist and turn in terms of what it might do to sterling and gilt yields as negotiations went on.”

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