CBA Global Markets Research
A Sterling Performance
GBP has rebounded strongly since mid‑July. Our GBP diffusion index shows that gains have been broad‑based.
Improvement in the UK economy, rising market interest rates & an unexpectedly quiet BoE MPC have supported GBP.
However, a number of fundamental issues remain that should act as headwinds to further large GBP gains.
The Great is back in the GBP
GBP has been a strong performer; outperforming the other G10 currencies, with the exception of the NZD, so far in H2 2013 (chart 1). On a trade‑weighted basis, GBP has risen by 4.4% from its late July lows. Furthermore, our diffusion index measuring GBP’s performance against 36 other currencies is close to its highest level since at least 2000 (chart 2). This illustrates the broad‑based nature of GBP’s gains.
The recent GBP strength is largely a reversal of the pattern observed in H1 2013. The cyclical factors that weighed on GBP earlier in 2013 have turned positive (see below). The pace of improvement in the UK economy has exceeded our own and the broader markets expectations. We continue to think GBP/USD will ease lower over the coming months in the face of a firmer USD; however the decline is unlikely to be as far as we previously expected.
From a tactical point of view, we think the current positive GBP sentiment is likely to be best exhibited against the EUR, CHF and JPY. Indeed, we think the recent decline in EUR/GBP can extend further. A near‑term strategy of selling into EUR/GBP rallies appears appropriate. In our opinion, EUR/GBP can push back down below 0.8200, driven by questions around the pace of the Eurozone economic recovery, the ECB’s dovish policy stance, positive UK developments and an increasingly negative German‑UK yield differential (chart 3). Additionally, when the UK side of the equation is combined with the improving global market sentiment and our long held view that there is a structural decline in Japan’s current account surplus; we think GBP will remain supported against the CHF and JPY.
Factors supporting GBP’s rebound
GBP’s outperformance has been driven by three main factors:
(a) An improving UK economy. Economic news flow out of the UK has consistently exceeded market expectations. In mid‑August, the UK economic data surprise index touched its highest level since November 2012.
More specifically, the UK economy expanded by 0.7% (QoQ) or 1.5% (YoY) in Q2. While still below trend, this was an improvement on recent quarters and was the fastest pace of annual growth since Q1 2011. Significantly, the growth in Q2 2013 was broad based with domestic demand and net exports contributing positively. The improving momentum in the UK economy, as illustrated by the sharp rise in the UK PMIs, implies a similar or even better rate of growth is probable in Q3.
In the August Inflation Report, the Bank of England (BoE) staff’s preliminary estimate for Q3 growth was 0.6% (QoQ). By contrast, our PMI based UK GDP equation estimates quarterly growth could exceed 1% in Q3 (chart 4).
(b) Rising UK market interest rates. The BoE Monetary Policy Committee (MPC) introduced forward guidance on interest rates in August. In summary, based on its current economic projections the BoE MPC does not expect to consider tightening monetary policy before 2016 (see CBA FX Strategy: Assessing our global central bank and currency outlook, published 26 August 2013).
Despite the forward guidance, UK market interest rates have risen sharply (chart 5). This has been a function of the run of better than expected UK economic data, rising global interest rates generated by expectations the US Federal Reserve will taper its asset purchases and the lack of overly dovish rhetoric from the BoE MPC (see below). The BoE’s forward guidance has not had the impact on financial markets many had expected.
The three‑month short sterling futures curve is now pricing in the first 25bpt BoE rate hike in H2 2014. This is sooner than the late‑2015 period expected in early May and mid‑2015 expected in early August. Market expectations remain far removed from the BoE’s forward guidance, which currently implies a rate hike is unlikely to be considered before mid‑2016 at the earliest.
Over 2013, movements in the GBP trade‑weighted index have been increasingly positively correlated with two‑year UK swap rates (chart 6). Hence, baring a shift in the BoE MPC’s rhetoric or a stumble in the UK’s economic recovery, UK market interest rates are unlikely to adjust much lower in the near‑term. Elevated UK swap rates should keep GBP firm in the near‑term.
(c) A surprisingly quiet BoE. Over the past few months, the BoE MPC has stressed that a premature tightening in UK financial conditions was a downside risk to the UK economic recovery. Hence, it is surprising the MPC has to date largely downplayed the recent UK market interest rate moves. For example, BoE Deputy Governor Bean noted that forward guidance is intended to clarify the MPC’s “reaction function and thus make policy more effective, rather than inject additional stimulus”1. Additionally, BoE Governor Carney stressed that focusing on market interest rates was missing the broader point. According to Carney the expected evolution in the BoE’s Bank Rate is most important for the UK economy, because around 70% of UK mortgages and 50% of UK business loans are linked to it2.
The tone of the recent BoE rhetoric suggests policymakers are still reasonably comfortable with the back‑up in UK market interest rates. As yet the MPC collective have not deemed the higher market interest rates as a risk to the UK economic recovery. Until the BoE changes its views, market participants are likely to keep focus on the positive UK data. The minutes of the September BoE MPC meeting are released on 18 September. The risk a small minority on the MPC began to express their concerns about the lift in UK market interest rates at the September meeting cannot be discounted.
Despite the positive momentum, fundamental issues remain
Some of the fundamental issues focused on by market participants earlier in 2013, and which weighed on GBP, remain in the background. A slowing in the UK economy’s growth momentum may see participants quickly re‑focus their attention on these issues. Irrespective, in the medium‑term we still think the factors outlined below are likely to act as GBP headwinds.
(a) The UK’s poor external position. The UK’s current account deficit is now 3.9% of UK GDP (chart 7). This is the widest it has been in over 20 years. In addition to a persistent trade deficit, the collapse in investment income inflows is adding to the UK’s current account deficit. The UK’s net income balance is now in deficit for the first time since 2000.
In terms of an external imbalance, a widening current account deficit is not necessarily problematic assuming capital account flows remain supportive. Apart from the lift in foreign direct investment in Q1 2013, UK portfolio and direct investment net flows have consistently been negative since late 2010. Consequently, the UK’s broad basic balance of payments, which captures the current account, net portfolio flows and net foreign direct investment is in deficit equal to 8.7% of UK GDP (chart 8). While this has improved from the 17.9% of UK GDP deficit recorded in Q4 2012, it remains historically wide.
Despite the lift in UK gilt yields, real UK yields remain negative out to eight years. Hence, any slippage in the UK’s growth momentum may reduce the UK’s ability to attract capital to finance its substantial external imbalance. The UK’s large external deficit should, over the medium‑term, limit GBP appreciation pressures.
(b) The durability of the UK recovery. Although the rate of UK economic activity has picked‑up, the level of activity remains depressed. The current UK recovery remains the weakest since at least the 1950s. This is a point the MPC continues to stress. At the same stage in the previous five UK recoveries, the economy was on average 11.6% larger than its pre‑downturn peak. By contrast, the UK economy is currently still over 3% smaller relative to its Q1 2008 peak (chart 9). Even based on the BoE’s upwardly revised August 2013 economic forecasts, the UK economy is not expected to reclaim its pre‑crisis level before H2 2014. This is six years after the downturn began.
The slow recovery highlights the significant challenges faced by the UK economy. There has been limited rebalancing away from consumption despite the near 17% decline in the UK’s broad Real Effective Exchange Rate since 2008. Household consumption remains the biggest driver of growth, having contributed 1%pt of the 1.5% annual growth in Q2 2013. The extent to which this can continue remains questionable. Elevated UK inflation (currently 2.7%pa) and subdued nominal wage growth (currently 1%pa) continues to squeeze UK consumers’ real wages. As a result, the recent increase in real consumer spending in the UK has been driven by a slump in the savings rate, which is now at a four‑year low of 4.2%. The long‑run average of the savings rate is 6.3%.
While this trend can be sustained in the short‑term because of improved credit conditions, a buoyant UK housing market and rising consumer confidence, over the longer‑term a pick‑up in real wage growth is needed to support consumption. Should real wage growth in the UK remain subdued, other sectors may be needed to carry a greater share of the growth burden. With the UK government continuing its austerity drive, and the recovery in the Eurozone, the UK’s largest export partner, expected to be rather anaemic, finding other sources of strong growth remains a challenge. These factors suggest the rate of growth in the UK economy is likely to slow from its current pace over coming quarters.
(c) Outlook for the UK labour market. A growing view among market participants is that the improving UK economy will see UK unemployment ease back down to the BoE’s 7% threshold more quickly than currently projected. This expectation was reinforced by the recent dip in the UK unemployment rate to 7.7% in July. At present the BoE MPC only foresees a greater than 50% chance UK unemployment falls below 7% in mid‑2016 (chart 10). Current market interest rate expectations imply market participants expect the BoE’s 7% unemployment threshold to be reached in H2 2014. The MPC currently views this as a low probability (around 20%).
The MPC’s less sanguine outlook for the UK labour market is driven by a number of factors. Firstly, according to BoE Governor Carney, although the MPC currently forecasts UK growth to average “around 2.5% per year over the next three years”, this is still below its historical average of 2.75%. In turn this implies “spare capacity will be used up only gradually”.
Secondly, based on the expected UK population growth, and decline in UK public sector employment, the fall in the UK unemployment rate to 7% would require the creation of “over a million new jobs in the private sector”. Since 2000, the UK private sector has on average added 44,000 new jobs per quarter3.
Thirdly, the lift in UK economic activity may not directly translate to faster jobs growth. Just over half of the jobs growth in the UK since mid‑2009 has been in part‑time jobs (chart 11). An increasing number of part‑time workers in the UK (now approximately 18.4%) would like to shift to full‑time work. Hence, as economic growth picks up, there may be a shift towards increasing an employee’s work hours, rather than hiring more staff. Furthermore, there is also significant scope for UK productivity to lift. The divergence between UK economic output and employment has seen UK productivity slip to be 15% below its pre‑crisis trend (chart 12). The UK’s productivity puzzle means that the average UK worker is now no more productive than he/she was in 2005. A rebound in productivity as output lifts should also temper the rate of decline in the UK unemployment rate. Going forward, a slower than expected decline in the UK unemployment rate is likely to see participants reduce their aggressive BoE rate hike pricing. This could dampen GBP demand.