Sterling gave up the $1.33 handle to trade at $1.3270 after some weaker-than-expected wage growth added to fears about an income squeeze following yesterday’s inflation rise. High inflation, low wage growth - this is the conundrum for the Bank of England. At present it doesn’t look supportive of a hike, but markets need to be ready for a hawkish hold.

Indeed the pound is at a crossroads ahead of tomorrow’s Bank of England monetary policy announcement. With Cable trading close to $1.33, it’s 11% (c13 cents) above its January lows and 11% (c16 cents) below the highs of June 23rd/24th before the Brexit referendum result collapse. Where do we go from here? There are a range of political and economic factors that will help shape the direction of the Cable over the coming months.

Rates

Looking ahead to the BOE meeting this week, the momentum behind the pound’s recent rise is down to interest rate speculation. Specifically, a bump up in inflation last month has got the market believing the Bank may choose to hike this year.

To summarise the outlook in Monday’s note, Bank of England Preview: Positioning for a hawkish shift?, while higher inflation is pushing up rate hike expectations, it does not appear to be enough to warrant any tightening this month. The stuttering wage growth figures and subsequent drop in cable reflect the fact that the conditions are not yet in place for any tightening.

Nevertheless, the rally in sterling looks ominous for a hike sooner rather than later, and a sign that the market is at long last starting to take seriously some of the more hawkish language we’ve heard over the last few months. In the minutes of its last meeting on Aug 3rd the Bank said that monetary policy could need to be tightened by a somewhat greater extent than financial markets are suggesting. Carney outright in the press conference that one hike over the next three years would not be enough to tame inflation.

For sterling bulls, disappointment at the August meeting has been replaced by hope again. The only significant change to back a hike this year is the inflation data and a return to the May peak of 2.9%. The market reaction seems to therefore be based largely on the MPC’s waning tolerance of above-target inflation, something it has consistently stressed.

However wage growth has failed to keep pace, muddying the decision. At the same time inflation is exchange rate rather than demand driven and therefore expected to retreat soon enough. Hopes of a hike by year-end may well be dashed on the rocks of economic uncertainty. In the short-term, cable may find it hard to hold onto gains if there is no additional indications from the Bank that it is prepared to hike this year. Today’s wage growth data would appear to temper any hawkish inclination, proving bearish for sterling in the near-term.

Brexit

The sterling trade has been highly politicised for well over a year with the pound sensitive to Brexit. It is interesting therefore to see the pound rally in spite of developments that would tend to favour a cliff-edge exit becoming more, not less, likely. Talks have been pushed back and there are big differences that are yet to be settled. The risk for the currency is that views on the exit bill and trade become crystallised for political reasons rather than pragmatic ones, heightening the risk of a cliff-edge exit. There does however seem to be some relief that the government was able to pass its repeal bill at its first Commons vote, which by simply transposing existing EU legislation will reduce the chance of ‘chaos at the borders’ on the day of exit from the EU.

UK economy

 

Macro-economic indicators are softer. GDP expansion was confirmed at 0.3% in Q2 but within this private consumption growth has slowed markedly. Household spending rose just 0.1% in Q2, down from the 0.4% registered in Q1 and well short of the 0.3% forecast. PMIs are showing signs of a slowdown in the all-important services sector. Macro data looks unlikely to surprise to the upside. An added risk is that a hike to interest rates will choke off growth.

The Fed

We await the Federal Reserve’s announcement of September 20th as the next key moment for direction in Cable. Dollar softness, which seems to be largely down to slacker growth expectations and waning hopes for a third hike this year, has contributed a significant part of sterling’s gains since January.

The Fed appears set to announce plans to reduce its balance sheet and will offer further guidance on the path of short term interest rates. On hikes to the federal funds rate, whilst the market seems to doubt the Fed’s desire to act again, conditions do not appear to have altered significantly enough to warrant taking the foot off the tightening gas. Another hike by December should not be ruled out.

On the balance sheet, taking a simplistic view, if QE was good for stocks and drove down bond yields then unwinding it will be bad for equities, while Treasury yields should rise and the dollar with them. The market may be underestimating the potential for a dollar bounce on the expected reduction of the balance sheet. USD has suffered significant losses this year but appears well placed for recovery with core inflation expected to turn higher in to year-end.

We must also note the imminent tapering of ECB bond purchases. With the interconnectedness of global real yields, this is likely to exert upward pressure on US yields and may further lend support to the dollar versus the pound.

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