The second quarter of 2008 marked yet another extended period of consolidation for the British pound as the currency simply range traded between 1.94 and 1.98 for the majority of the time. In fact, the currency ended little changed from the start of April, and for that matter, the beginning of the year! The second quarter started out with a bang as the Bank of England cut the Bank Rate by 25 basis points to 5.00 percent amidst signs of distress in the financial sector and a housing-led economic slowdown in the UK. However, the scenario rapidly became more complex for the UK’s Monetary Policy Committee (MPC) as time went on, as consumer price inflation started to accelerate on the back of surging oil and food costs. As the third quarter begins, the Bank of England is still grappling with these issues, and the future of the British pound will continue to depend upon whether the MPC opts to focus more on the economy and the financial markets or rising price pressures.
The Bank of England Weighs the Risks
A Slowing Economy…
Domestic activity in Europe’s second largest economy has clearly shown signs of stumbling in recent months. According to the Office of National Statistics, growth during the first quarter of 2008 cooled to a 2.3 percent annualized pace – marking the slowest clip of expansion in more than two years. In comparison to activity in the US, which expanded a tepid 1.0 percent over the same period, growth in the UK may look otherwise impressive. However, key sectors of the economy have clearly faltered and threaten to sabotage activity going forward. The biggest anchor to expansion going forward is from the souring of the decade long housing boom, which threatens to erode consumer wealth. According to HBOS, the country’s largest mortgage lender, home prices have fallen or stagnated since the start of the year, and slipped 2.4 percent during the month of May alone. Furthermore, the British Bankers’ Association reported that mortgage approvals fell 56 percent in May from a year earlier to 27,968, which was the lowest level since record-keeping began in 1997. Indeed, with lending standards now significantly tighter following the credit crunch, already-weak demand for homes in the UK is taking a hit.
The decline in UK property values, among other factors, is taking a toll on consumer confidence as GfK’s measure fell to a more than 17 year low of -29. The pessimistic turn has come despite the fact that unemployment has held at its lowest rate since 1975 for seven consecutive months. This trend may not continue for long, however, as business activity has slowed markedly amidst an astronomical rise in raw material costs that threatens to squeeze profit margins. One of the sectors most heavily hit with increased costs is manufacturing, as the May reading of the purchasing managers’ index (PMI) slipped to 50, indicating that growth stagnated. Other sectors were not immune to a broad slowdown either, as PMI for the construction and services sectors both fell below 50, signaling an outright contraction in activity. Given these and other factors, the Bank of England expects GDP to slow markedly throughout the rest of the year to a 15-year low of 1.3 percent by the fourth quarter.
A Feeble Financial Sector…
While concerns about the health of the financial markets and the impact of the credit market freeze have died down significantly, the topic is undoubtedly still on the minds of the Bank of England’s MPC members. From a global standpoint, few countries stand to lose more from a prolonged and severe crisis than the UK. British commercial banks and lenders have nearly buckled under the pressure, and in early June, Bradford & Bingley, the UK's largest lender to landlords, said they would sell shares at a 33 percent discount amidst deteriorating housing market conditions. The news led Fitch Ratings to cut its long-term default rating and placed the firm on “watch negative,” and while B&B’s Chairman affirmed that the company remains “well capitalized,” the news made it obvious that the UK’s financial sector was far from stable. While the Bank of England acknowledged that the market correction was almost necessary “after an extended credit boom” in their most recent Financial Stability Report in May, they also cited other concerns. More specifically, they noted significant risks associated with mortgage-backed securities in the UK, particularly commercial ones. The fear is that if commercial property values plummet like residential values have, write downs on commercial mortgage-backed securities could be the next trigger for yet another global credit crunch that would take its harshest toll on the UK.
Rocketing Price Pressures Have Pushed Inflation Well Above Target…
On June 16, 2008, Bank of England Governor Mervyn King wrote a letter to Chancellor of the Exchequer Alistair Darling explaining how the consumer price index (CPI) had surged to a nearly 16-year high of 3.3 percent , well above the Bank’s 2.0 percent target. Mr. King went on to cite “unanticipated increases in…food, fuel, gas and electricity” as the culprit, and also forecasted a continuous rise in CPI above 4 percent. However, the UK is not alone, as regions including the Euro-zone, US, and emerging market economies like Mexico and Turkey are dealing with similar inflation pressures. While an increase in price pressures is disconcerting in itself, central banks tend to become more concerned with the public’s inflation expectations. Indeed, this can spark a dangerous cycle as lofty forecasts by a nation’s citizens can lead to higher demands for wages, which will raise costs for businesses, and may subsequently lead them to raise sale prices, and so on. As a result, the Bank of England is understandably anxious to nip inflation in the bud.
What Will The Bank of England Do?
At the close of the second quarter, the markets were betting that the Bank of England would raise the Bank Rate by 25 basis points to 5.25 percent by November. Given the rapid acceleration in inflation and Mr. King’s forecasts that CPI would rocket above 4 percent, the market’s judgments seem reasonable. However, it is Mr. King’s letter to the Chancellor that suggests the Bank of England may, in fact, leave rates steady. Unlike the European Central Bank which raised interest rates in early July – the BOE has a dual mandate to maintain price stability and to promote sustainable growth and employment. The UK has already seen indications of a broad economic slowdown, but adding the fragile nature of the UK’s financial sector to the mix puts the Bank of England in a particularly precarious position, as a rate increase meant to fight inflation could easily push the UK into recession and trigger a severe credit crisis. As a result, the UK's MPC will likely continue to sound hawkish on inflation in order to contain consumer inflation expectations, but when it comes down to it, their bark may be bigger than their bite, as the Bank of England is highly unlikely to actually raise rates during the third quarter.
A New High in EUR/GBP?
Like the GBP/USD, EUR/GBP spent much of the past quarter in a broad range. However, this was only after the pair rallied to record highs in early April. While some may attribute the pair’s progress to the euro’s strength alone, the pound’s weakness played just as much a role in the upside momentum. From a fundamental standpoint, the exchange rate draws a stark contrast between two currencies with dramatically different economic and interest rate outlooks. After three 25 basis point rate cuts since December, the UK economy is still struggling to stay afloat. On the other hand just raised interest rates in July.
Such a disparity between the two geographically close nations and the sharp weakness of the British pound against the Euro has helped to prevent a more major downturn in the UK economy and UK trade. While the country is looking at a potential housing collapse and the worst pace of economic growth since its last recession, policy officials have forecasted moderating yet steady growth for the Euro-Zone through medium term. As a result, risks remain to the upside for the EUR/GBP pair during the third quarter.
GBP/USD Technical Outlook
By Jamie Saettele
We presented an alternate count last quarter, mentioning that “the decline from 2.0396 is wave X in a larger upward complex correction from 1.9337. Under this scenario, the GBPUSD would exceed 2.0396 before falling hard in the larger C wave towards 1.85.” The alternate has become preferred. The GBPUSD consolidation since 1.9337 is either a flat or triangle. If a triangle, then the pair probably tests 2.02 in wave C of the triangle before completing waves D and E in a tighter range. If a flat, then Cable will exceed 2.04 but reverse ahead of 2.1160. We favor the latter, more bullish count, due to COT positioning and the EURUSD bullish structure.
