The surprising Bank of England

If the UK’s monetary policy is not as dull as he thinks it should be, BOE governor Mervyn King has to look no further than his own office to find the culprit.

Bernanke is committed to making Fed decision making more transparent and has created a committee to find ways to improve its communication. At the ECB, President Jean- Claude Trichet has developed a stable of word clues (e.g., “strongly vigilant”) to signal its policy intentions. But the BOE almost seems to glory in surprising the market, which it has done not once but twice in the past several months.

In fairness, the timing surprised the market more than the direction of rates. King clearly indicated the BOE’s economic forecast assumes another hike in rates to 5.50 percent, taking the British rate above the U.S. fed funds rate for the first time in a couple of years.

The market expects the hike to be delivered in the second quarter. It may be difficult to surprise the market a third time, but it is possible. The market does not like surprises and requires compensation for the risk. An increase in risk premium around BOE meetings is the likely price for the BOE’s tactics.

It seems almost inevitable that the UK’s Chancellor of the Exchequer, Gordon Brown, will become the next Prime Minister when Tony Blair steps down later this year. At this juncture, it is not clear that Brown will be able to seek a public mandate by calling for elections. Just as the British electorate grew weary of the Tories under the long reign of Margaret Thatcher and John Major, it now seems fatigued with the Labour party. Remember this is an electorate that loved Winston Churchill but turned him out of office, too.

In another way, though, Brown’s vexing situation is symptomatic of a larger challenge within the other G7 countries — weak governments. Canada has a minority government. In the U.S., there is a divided government for the first time in seven years. President Bush’s public approval rating is low and posturing for the 2008 presidential race has already begun. France goes to the polls this spring and there is much speculation of President Jacques Chirac’s legal problems as soon as he loses the immunity of his office. Italy’s center-left coalition was strained over the budget vote at the end of 2006 only to collapse in February over a minor foreign policy decision. Germany has a grand coalition government of the two main parties, the CDU/CSU and SPD.

The weak leadership does not appear to be much of a market consideration at the present. However, should circumstances arise that demand bold leadership, the markets will exact a price for its absence.

The pound (GBP) has traded above $1.90 a handful of times over the past quarter of a century. Although it might spend a few months above this level, it has not sustained these moves. By some measures of purchasing power parity, sterling is one of the most over-valued of the major currencies — which is not to say sterling is about to collapse or that it cannot make another push through $2.00.

However, the overvalued pound is likely to influence investors in a couple of channels. We would expect investors to respond by taking advantage of upward spikes to layer in hedges, especially on fixed-income exposures and after the BOE tightening cycle appears to have peaked. Also British corporations may increasingly become acquirers in the global M&A boom to take advantage of the strong sterling.

Investors who have not been dissuaded by the high price of the pound from purchasing a real UK asset may prefer to borrow the currency rather than buy it. Offsetting a pound asset with a pound liability neutralizes the currency exposure.