GBPUSD continues to hold a little way above seven-month lows but looks susceptible to any drop in sentiment as tense and tough negotiations over Brexit commence today (June 19th).

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Sterling traded above $1.28 in early trading as markets look for clues about where the talks are going to take the country. 

There are several competing forces that are pulling the pound in different directions. It's a pretty simple case of hard v soft Brexit while the Bank of England's shift of tone adds another dimension. 

Currently the government is negotiating based on leaving the single market and customs union with the aim of negotiating a comprehensive free trade deal. This hard but smooth Brexit is weighing on the pound. But we also see a chance that all the chaos could result in a softer Brexit. For example fresh elections might lead to a Labour government that favours remaining in the single market. All the uncertainty is exerting just about equal force, leaving the pound in limbo for the time being.

Meanwhile, the Bank of England just got interesting again. Sterling jumped and the FTSE 100 took another leg lower after a significant hawkish surprise from the Bank of England last Thursday. Having traded around the $1.27 handle, the pound leapt to just short of $1.28 as the Monetary Policy Committee appears increasingly concerned about inflation.

The MPC held rates as expected but policymakers voted 5-3 - the main takeaway is that the Bank is a lot closer to hiking than previously thought. It looks like rising inflation and falling real incomes is at the forefront of policymakers’ minds. As previously noted, the widening gap between inflation and wages poses a significant challenge for the Bank and it was indeed lower household income growth and persistent low consumption that formed the focus of the meeting’s discussions.

Nevertheless, the majority still back no hike. Inflation is due to external factors, chiefly the weaker exchange rate, and the MPC thinks that despite the recent uptick there ought to be no ‘adverse consequences’ for inflation expectations further ahead. The jump in inflation is temporary and most policymakers can look through this still. They still think that pay growth, while modest, will pick up ‘significantly’ over the forecast period. It thinks the pay squeeze won’t last.

Despite this, the Bank admitted that the overshoot of inflation ‘might be somewhat greater than previously supposed’. It also suggested that wage growth could suffer further if slower growth results in some margin of slack reopening. The pay squeeze will get worse before it gets better – but no reason to jump the gun on hiking.

However it’s clear data over the last three days is a growing worry. 

We’ve had a triple-whammy of rocky data that all points to a significant slowdown in Q2 growth from what was already a pretty horrid Q1 print.

The first leg of this unstable little milking stool is inflation, which is rising more quickly than the Bank had anticipated as recently as a month ago. From 0.5% last June it’s jumped to 2.9% in May. What is interesting and of concern is the acceleration this year as sterling weakness starts to bite hard. CPI has spiked from a sustainable 1.8% in January and shows no signs of slowing down. It is likely to breach this summer. At the same time wages including bonuses are climbing at just 2.1%, creating a yawning gap between earnings and prices. Combined the effect on the economy is drastic. Slumping retail sales figures are the result as consumers rein in their spending.

The effect on GDP growth will be significant.  As the ONS points out, growth slowed to 0.2% in Q1 2017 as ‘consumer facing industries such as retail and accommodation fell and household spending slowed’. Q1 inflation was running at around 2.2%; Q2 is looking more like 2.8% and could rise when June’s numbers are released.

As noted yesterday, the Bank is in a tough position. A hike could derail what growth there is, hurt homeowners with mortgages and sap business confidence further. But failing to act could hurt the credibility of the Bank in terms of its mandate. There is certainly an argument that hiking now will help limit the drop in real wages and support consumer spending. If the gap between inflation and pay growth widens much further over the summer we could easily see the Bank hike.


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