The Bank of England (BOE) released its latest Inflation Report last week on August 13th. It did not contain any startling revelations, but it was interesting and relevant nonetheless. I provide a summary of what seems most relevant from the prospective of someone trading the British pound (NYSEARCA:FXB).
Economic Optimism Comes with A Laundry List of Caveats
As recent data have shown, the economy in the United Kingdom has experienced strong performance. From Governor Mark Carney's introductory remarks:
Robust, broadly based growth over the past year has taken output above its pre-crisis peak. The MPC has revised up its expectation for near-term growth to 3½% this year and we now expect headline activity to slow a little later than we had previously thought. Unemployment has fallen sharply and is now expected to drop below 6% by the end of the year and to around 5.5% by the end of the forecast period - a marked reduction relative to our expectations in May.
And from the Q&A session, Carney provided additional good news:
…thus far growth has been relatively broad based. This is not a debt fuelled consumption recovery. The recovery element wasn't that; there was a pickup in investment that we had expected and did come through.
Consumer spending has grown for ten straight quarters and is closing in on its peak in the fourth quarter of 2007. The Inflation Report notes that most of this growth has been funded from household income although consumption growth has outpaced income growth since the middle of 2012 (the saving ratio has declined).
Lest exuberance take hold of the crowd, send bond yields skyward, and take the British pound to higher heights, Carney as usual cautioned the audience that "this expansion faces some challenges." Here is a summarized list of the economic "gotchas" sprinkled throughout the verbal and written components of the Inflation Report:
- "Muted demand in [the UK's] major export markets, which is being reinforced by the persistent strength of sterling , now 14% above its trough in March of last year"
- Continued structural adjustment in the eurozone
- A likely tightening of financial conditions as the global recovery continues
- A global imbalance between saving and investment that has not improved since the financial crisis
- Lower than expected productivity growth and the uncertainty in how fast and when it will pick up
- A sharp slowdown in domestic demand triggered by higher borrowing costs (economic growth remains highly dependent on low interest rates)
- Disappointing growth in real incomes
- "Ongoing balance sheet repair in the public and private sectors"
- Intensifying geopolitical risks (note Carney indicated these risks do not directly influence monetary policy)
Among these cast of dour characters, productivity growth took center stage this time as it was the focus of the first pointed question in the Q&A session. During that session, Carney also pointed out "if there's one big issue, if I could pick one big issue about the sustainability of that recovery it is the extent to which productivity does pick up."
Productivity growth is barely above its post-recession lows and well off its pre and post-recession peaks. The Monetary Policy Committee (MPC) expected productivity growth of around 1% for 2014. Instead, four-quarter growth in hourly labor productivity was 0.4% in the first quarter and is now expected to be slightly negative in the second quarter. This is a notable downgrade, and Carney acknowledged that the Bank has significantly reduced its expectations for productivity growth. This realignment also translates into a more pessimistic outlook for wage growth. These data become a bit more important in assessing the BoE's mood on the economy because the Inflation Report pins the recovery on future improvements: "Over time, a sustained revival in productivity and real household incomes is expected to underpin the expansion."
An economy with a lower threshold for interest rates
One of the more fascinating components of the economic discussion revolved around the conclusion that there was more slack in the UK economy than originally assumed. Slack in the economy is getting consumed faster than expected yet also producing a greater supply of labor at given wage rates. From the Inflation Report:
Strong output growth has yet to be matched by a material pickup in productivity, however. Instead employment gains have been exceptionally strong and unemployment has fallen sharply. The strength in labour market quantities has contrasted with the weakness of wage growth, increasing the uncertainty about the current degree of spare capacity. It seems likely that slack over the past year or two has been greater than previously thought; it also seems likely that slack is being used up at a faster rate than expected. In light of the heightened uncertainty about the current degree of slack, the Committee noted the importance of monitoring the expected path of costs, particularly wages, in assessing inflationary pressures…
…it also seems there has been an increase in labour supply at a given wage rate…Whatever the causes, these developments point to the economy being able to sustain a higher level of employment and lower rate of unemployment without generating additional inflationary pressures. Indeed, continued low wage growth has enabled firms to expand their margins despite the sharp increase in employment.
In other words, the Bank of England feels incrementally LESS pressure to raise rates or worry about incipient inflation from the economic expansion.
The current acceleration in job growth has increasingly gone to lower paying jobs. Given the vast majority of jobs are still in highly skilled occupations, and given the supply of labor has expanded at given wage rates, I am assuming that increase in jobs for lower-skilled workers is a good sign. That is, the economic expansion is finally reaching out broadly and allowing a wider-spectrum of worker to participate. If I am correct, this development is a major positive and should become a boost for confidence in the economy.
Employment growth by occupational skill level
Source: Bank of England August, 2014 Inflation Report (page 29)
The distraction of timing the first rate hike
On June 12th Carney gave a speech at Mountain House that surprised the market with a warning that rates could rise sooner than expected. At the time, I claimed that the market's response to rush into the pound was "over-eager." I even recommended against chasing the move (sure enough, the momentum only lasted three more weeks before completely reversing…I used the pullback to scale into long positions but cooled my heels a bit after the British pound broke down below its critical 200-day moving average against the U.S. dollar). From my piece:
I think this surge is a gross over-reaction: the market overly focused on the changed timing of the first rate hike and not the unchanged overall trajectory and scope of those rate hikes.
Carney underlined this point during Q&A when he reprimanded Jonathan Ferro from Bloomberg Television for putting too much importance on the timing of the first rate hike (emphasis mine):
…first off you're the one putting tremendous emphasis, collectively, on one move in rates, you know that's the great focus - is when is the Bank going to move the first time? What we're putting emphasis on, and I know it's boring and repetitive and it doesn't clip into a new headline, we're focusing on the path, the likely path of rates, the limited and gradual adjustment in those rates over the medium term, because of the headwinds that are facing this economy….what's important is the broad point [we'll] determine the precise path as we go.
Interestingly, in response to another question on the June 12th speech, Carney seemed to indicate that the real point of that occasion was to get the market to sculpt rate expectations around the economic data…even if the data are volatile…
And what we've seen since Mansion House is that market reactions to economic surprises, particularly economic surprises in the UK, have moved back to their historic averages, around their historic averages. So if you look at one year, one year forward, interest rates as one proxy for that, those reactions, to good or bad surprises, have been more consistent with the reactions we saw prior to the financial crisis. So it came from extremely low levels up - now a relatively limited period of time.
Ferro's Bloomberg colleague Emma Charlton from Bloomberg News provided a face-saving follow-up question that raised a great point on timing:
How critical is it to start earlier with rate increases if you do intend to commit or you do intend to be gradual and limited? And if spare capacity is being used up more quickly than you thought and you've said the recovery is sustainable, doesn't that argue for going earlier to enable this gradual and limited path?
Carney essentially punted on this question by dismissing it as a consideration on the margins of the BoE's decision-making.
I continue to expect the British pound to surge when the BoE finally makes its first rate hike. However, the surge will lose momentum relatively quickly and settle into some (new?) trading range as subsequent rate hikes will hardly be a surprise given the BoE's guidance of "gradual and limited." In fact, from the point of the first rate hike, most surprises should be on the downside for some amount of time.
The British Pound
I was of course most interested in direct commentary on the British pound.
The currency was discussed during the Q&A session mainly in the context of next month's Scottish referendum on independence from the United Kingdom. The Inflation Report noted that the 2% gain in the British pound since the May report was higher than expected. I take this to mean the appreciation was also more than desired. The appreciation in the pound has benefited consumers with lower import prices. The Inflation Report also shows that the UK has not suffered any damage to its trade balance from the higher currency. Indeed, toward the end of the Q&A, Deputy Governor Minouche Shafik effectively noted that the BoE's outlook on the economy is not reliant upon a recovery in the eurozone anytime soon - domestic demand is the stronger driver in the economy. Nonetheless, exporter margins have been hurt even as volumes have not been hit. The BoE is also uncertain of the potential for lagged impacts on exporters from past currency appreciation.
While the Bank of England hints at some unease with the overall appreciation, the British pound is still well off its pre-crisis levels as seen in the following chart (ERI = effective exchange rate):
Sterling exchange rates
Presumably, the normalization process that the BoE references should include a higher currency even if not one that challenges its pre-crisis highs anytime soon.
Moreover, the appreciation in the pound is well-supported by differentials with global economic growth. This is a dynamic I have been discussing and anticipating since Mervyn King left the Bank of England in mid-2013 dropping plenty of hints referencing the good economic news on the horizon.
Relative revisions to Consensus domestic demand growth
forecasts for 2014-16 and sterling ERI
Given this chart, the Inflation Report points out "in recent years, movements in sterling have tended to correlate well with revisions to forecasts for UK domestic demand growth relative to that for the United States, euro area and Japan." Since March, 2013, interest rate differentials have accounted for about 50% of the currency's gains. The Inflation Report concludes this is an unusually large proportion. I assume the implication is that BoE will be even more cautious about moving too far ahead of its economic partners with rate hikes since it means the British pound could race even faster. In fact, clear reticence in following up the first rate hike with additional hikes could provide one of the early downside surprises for the British pound during that time.
Regardless, I do not want to get too far ahead of the trade here. First things first…I will continue watching the economic data and, even more importantly, the market's reaction to that data.
Be careful out there!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In forex, I am long the British pound.