The pound’s rally runs out of road

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Over the last three months, the pound has ranked as the world’s best per­form­ing ma­jor cur­rency. Sup­ported by the rel­a­tively strong growth of the UK econ­omy - GDP grew at 3% year-on-year in the first quar­ter - a buoy­ant property mar­ket, and hints from Bank of Eng­land gover­nor Mark Car­ney that he could be­gin to raise in­ter­est rates be­fore the end of this year, the pound has climbed 2.25% since midApril to touch a post-cri­sis high against the US dol­lar. How­ever, there are grounds to be­lieve ster­ling may not have the legs to make sig­nif­i­cant fur­ther gains in the near term. At US$1.71, the cur­rency is now look­ing close to the top of its range against the US dol­lar.

One rea­son to doubt the pound’s stamina was on dis­play last Thurs­day, when hun­dreds of thou­sands of Bri­tain’s state sec­tor em­ploy­ees staged a one-day strike to de­mand higher pay. De­spite heart-rend­ing tales in the me­dia about the hard­ship suf­fered by nurses, fire-fighters and lol­lipop ladies, the strik­ers failed to garner the gen­eral pub­lic’s sup­port.

That’s be­cause state sec­tor work­ers have done well in re­cent years com­pared to their pri­vate sec­tor coun­ter­parts. Since 2008, the aver­age pub­lic sec­tor wage has risen by 2.1% an­nu­ally, com­pared with just 1.3% in the pri­vate sec­tor. Greater wage flex­i­bil­ity among pri­vate businesses has al­lowed job cre­ation in the sec­tor to re­cover, with to­tal pri­vate sec­tor em­ploy­ment now at a record 25.1 mln, up from 23.5 mln at its pre-cri­sis peak in 2008. As a re­sult, the UK econ­omy has beaten most fore­casts, prompt­ing the mar­ket to bring for­ward its ex­pec­ta­tions of rate hikes.

Those ex­pec­ta­tions may be over-blown. Re­cent weak wage growth will be one of the key in­di­ca­tors the BoE will con­sider to gauge the strength of the UK econ­omy and the amount of slack in the labour mar­ket. In its May in­fla­tion re­port, the Bank es­ti­mated the slack to be 1% to 1.5%. In other words, April’s un­em­ploy­ment rate of 6.6% was only around 1ppt above the es­ti­mated non-ac­cel­er­at­ing in­fla­tion rate of un­em­ploy­ment.

There are other rea­sons why ster­ling will not move much higher.

1. At 1.5%, in­fla­tion is sub­dued, well be­low the BoE’s 2% tar­get. In­fla­tion­ary pres­sures are be­ing kept in check by the strong pound, which is help­ing to fuel a su­per­mar­ket price war. Mean­while, poor pro­duc­tiv­ity growth is lim­it­ing the prospect of fu­ture wage in­creases. There are some signs that pro­duc­tiv­ity growth may be­gin to pick up, as busi­ness in­vest­ment has grown for five con­sec­u­tive quar­ters. Mean­while, some sec­tors are suf­fer­ing skills short­ages, which will start to put up­ward pres­sure on wages.

2. The UK’s first quar­ter eco­nomic out­per­for­mance was achieved against the back­drop of a bad weather-in­duced soft patch in the US. The lat­est jobs data show the US econ­omy is now ac­cel­er­at­ing again, with un­em­ploy­ment fall­ing to 6.1% and June’s non-farm pay­rolls well above aver­age at 288,000. In con­trast, the UK’s eco­nomic data ap­pear to be soft­en­ing. Con­struc­tion out­put slowed last week to 3.5% year-on-year and ex­porters are strug­gling with the strength of the pound. Over the last year, ex­ports have con­tracted - 4.2%. In short, the UK’s rel­a­tive out­per­for­mance has di­min­ished. If the US econ­omy ac­cel­er­ates fur­ther, ex­pec­ta­tions will rise of an early rate hike from the Federal Re­serve, re­duc­ing ster­ling’s rel­a­tive at­trac­tive­ness.

3. House price rises of 10% y-o-y across the UK and 25% in Lon­don have in­creased pres­sure on the BoE to raise rates. How­ever, the Bank re­cently in­tro­duced a new set of macro­pru­den­tial tools in­clud­ing lim­its on mort­gage-to-in­come ra­tios and more strin­gent stress tests of bor­row­ers’ ex­po­sure to rate hikes. The lat­est data sug­gest the tools may be work­ing, with sur­veys sug­gest­ing that the Lon­don mar­ket has lost mo­men­tum.

All these fac­tors - weak wage growth, plen­ti­ful labour mar­ket slack, low in­fla­tion, strug­gling ex­porters, mod­er­at­ing growth, and the new macro-pru­den­tial con­straints on the hous­ing mar­ket - sug­gest rate hikes will come later rather than ear­lier, di­min­ish­ing the pound’s at­trac­tive­ness against the US dol­lar, es­pe­cially if the US econ­omy ac­cel­er­ates fur­ther.

Against the euro, it is a dif­fer­ent mat­ter. The Euro­pean Cen­tral Bank is still in eas­ing mode and rates are likely to stay low for at least two years, widen­ing the in­ter­est rate dif­fer­en­tial be­tween the UK and the eu­ro­zone and sup­port­ing the pound against the euro.

Em­ploy­ment and in­fla­tion data to be re­leased this week should give a bet­ter in­di­ca­tion of where the BoE stands in gaug­ing the strength of the econ­omy. Still, it looks likely that ster­ling has lit­tle room to move higher from here.

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