By David Veitch
A EUR/GBP depreciation is likely.
As of late, the U.K. economy has shown spirited signs of life. On October 26, British GDP growth came in at .8% for the July-September period, twice economists’ expectations. This strength prompted a rally in the pound vis-à-vis the euro, and led Standard & Poors to raise their outlook on high-quality British gilts to stable. As well, a hawkish inflation report on November 10 has decreased expectations that the Bank of England (BoE) will engage in further quantitative easing, which has supported the pound.
The pound’s recent rise versus the euro (a decrease in EUR/GBP) is indicative of a new period of pound strength, and it is likely the appreciation will continue into the near future. The strong U.K. inflation outlook, and the deteriorating situation of EU peripherals, gives the indication that EUR/GBP will continue to drift lower.
A Strong Inflation Picture
U.K. inflation is crucial to the pound’s direction as it will determine whether the Bank of England expands its asset purchase program past the £200 billion which it has already made. The November inflation report makes an expansion seem unlikely given that CPI is growing at roughly 3%, much higher than the 2% level targeted by the Bank of England.
Going forward there are a number of factors which point to continued high inflation, therefore limiting the prospects for further QE. On one hand, recent surges in commodity prices after the Fed’s decision to inject $600 billion into the US economy are unlikely to abate given strong growth in emerging economies (i.e. China) and recent signs that OECD oil demand is picking up.
Also, as part of a package of reforms introduced by David Cameron and his conservative government, the U.K.’s value-added-tax (VAT) will be increasing from 17.5% to 20% in January 2011. This will push on inflation, much like Canada’s recent HST tax increase did. There is an important link between this expected tax hike and current inflation. Under the definition of Ricardian Equivalence current period consumption is expected to increase if future taxes are expected to increase. Therefore, some may argue that current U.K. inflation data is being artificially pushed up by forward looking individuals (or at least individuals encouraged to be forward looking by retailers) buying in 2010 in order to beat the VAT increase. However, contrary to what the hype suggests, this is unlikely to be occurring on a grand scale given the relatively tight credit conditions which exist in the U.K. economy.
Question Marks to Inflation
There are two looming threats to the inflation outlook in the U.K. One of them, a stronger pound pushing down import prices as a result of the continuation of the euro crisis, only serves to prove the case to short EUR/GBP. The other threat is the Conservative’s fiscal tightening, due to begin in 2011. The fiscal tightening includes a total of £81 billion of cuts through 2011-2015 with almost all government budgets being cut; a notable exception is the National Health Service (NHS) which has been “ring-fenced” from potential cuts.
The cuts have been controversial within Britain with items such as the 2013 elimination of the child benefit for families in high tax brackets causing a stir. However, the market is giving more and more credibility to the U.K. government following through on the plan. This can be shown by the decrease which has occured in 10 year zero real yields after the spending cuts were revealed on June 22.
The risk from these cuts is that a drop in spending could damage the U.K.’s growth prospects, and hence inflation, sparking further QE and delaying BoE rate hikes. George Osborne has even hinted that if the cuts have too sharp an effect on the economy, a monetary policy response may be appropriate. However, given that the BoE still expects inflation to average 3% in 2011, a deflationary scenario in 2012 seems somewhat unlikely given the improving prospects for a global economic recovery. Deflation could possibly be brought about by sluggishness in the eurozone periphery dragging on U.K. growth; however, under such a scenario investors would be likely to shy away from euro denominated debt which would make any EUR/GBP appreciation limited.
A View to the Peripheries
Perhaps the strongest case for an appreciation of the pound in the near-term is the deterioration in the situation of the eurozone’s periphery. After the Greek crisis in May the eurozone had a strong summer led in large part by strong growth from Germany. However, output in the eurozone has not been able to come close to its pre-crisis peak, and unemployment is still rampant. In September, German unemployment fell, but unemployment throughout the entire eurozone rose from 10% to 10.1%. Spain’s unemployment rate has continued to rise and currently sits at 20.5%. As well, in 2011 a number of austerity packages will be implemented, potentially worsening the unemployment situation in the periphery.
Furthermore, a continuation of Ireland’s fiscal woes is likely to drag on the euro. The market for Irish government bonds has been described as a buyers strike, and the likely outcome from this drama is severe austerity for Ireland. Best describing the mess is a quote from Morgan Kelly who says: “Although insolvent, Ireland is still liquid, for now”. Delaying a complete default from happening is Ireland’s current €20 billion cash pile which should last it until the middle of 2011. During the Greek crisis EUR/GBP briefly tested the .80 level; at its current level of .85 it still has a lot of room to move downwards.
A Strong Case Going Forward
Given the strong inflation outlook in the U.K. and the troubling situation in the eurozone, the pound sterling truly has entered a new period of strength against the euro. Especially when considering how the pound has weakened significantly since the beginning of the crisis, most signs point to a continued downtrend in the EUR/GBP.
- BoE Inflation Report
- “Foreign Exchange Outlook”, November 2010. Bank of Nova Scotia.
- “GBP – To QE, or not to QE . . .”, Octoboer 2010. HSBC.
Disclosure: No positions