[Originally published on 8/14/2014]
By Neil Staines
"The road to success is always under construction” - Lily Tomlin
As we have noted many times over the past few months we are broadly ambivalent as to the fortunes of GBP against the USD in the current environment. As US growth rebounds and interest rate expectations begin to shift towards normalisation, exposing a clear divergence between US and Eurozone policy, there is a growing case for USD strength. Furthermore, we maintain the view that the USD remains broadly undervalued and as monetary divergence unfolds, we continue to favour GBP and USD vs. EUR (and to a lesser degree due to monetary inactivity and geopolitical risks, the JPY).
This morning, we have seen further evidence that the economic backdrop for the Eurozone is deteriorating with Germany’s Q2 GDP contracting 0.2% q/q matching the very poor Italian performance for Q2. France also disappointed expectations with a second consecutive quarter of stagnation – a performance which led the French Finance Minister Michel Sapin to declare that "France will not meet its deficit target this year.” German growth felt the pinch from the decline in global export activity as net exports detracted from growth in the quarter, which was further dented by the fall in construction spending that was seemingly brought forward into Q1 due to mild weather. Our sentiment is largely summed up by ECU Global Macro Team member, Kit Juckes, who said this morning:
"That just highlights Draghi’s problem. Too little growth to stop the debt snowball, a vicious cycle of fiscal austerity and lack of aggregate demand staying in place and dooming Europe to Japanification.”
The main focus yesterday was Bank of England Governor Carney and his delivery of the August Quarterly Inflation Report (QIR), preceded by yet another strong UK employment report. We have noted before that the base effects of delays in bonus payments last year have weighed on earnings growth figures, but beyond that the wage inflation / productivity puzzle continues to … puzzle. Despite the continued strength in what the BoE refers to as the ‘quantity measure’, or the nominal rise in employment, the weakness in wage growth (and ultimately its implications for the BoE mandate of inflation) dominated sentiment and price action.
Infamy, Infamy, they’ve all got it in for me!
Historically, GBP has been very sensitive to interest rate movements and relative yield differentials. With rates having been ‘on hold’ for such a long time at the effective zero bound, that sensitivity has been heightened. On that basis, the reaction of short sterling interest rate futures after yesterday’s QIR is significant. The boost in GBP (GBPUSD through 1.70) came after the (now infamous) June Mansion House speech where Carney indicated that a rate rise "could happen sooner than markets currently expect.” In delivering the August QIR yesterday, Governor Carney came under further criticism for the Bank’s forward guidance (alleged) inconsistencies and the heightened uncertainty with which Carney described the expected paths of wage growth and productivity, led markets to price a lower probability of a 2014 rate hike than was priced at the time of the "sooner than markets expect” rhetoric. This undermined GBP on foreign exchange markets.
Dissent in the ranks?
With the data calendar fairly light for the rest of the week, there is a risk that the decline in GBP extends in the short term. However, there was one comment from the QIR report which brought an extension of GBP’s decline, where we disagree with the markets’ interpretation. Carney stated that "Now is not the time for a rate increase.” Our viewpoint on this is that if there were a case for a rate hike now, then it would have been implemented last Thursday. That is not to say that a rate rise will not be deemed appropriate in Q4. Indeed, we still believe that there is a strong possibility of a hawkish dissent from last Thursday’s meeting when the minutes are released next week.
In short, the disappointing wage growth and the Governor’s disappointing lack of conviction have dented GBP in the near term. However, we maintain the view that on both economic and monetary differentiation, GBP should resume its outperformance against its Eurozone counterpart once this "healthy” short term market setback has run its course. Similarly, recent sessions have seen disappointing progress from the USD, however we mirror the sentiment of Carl Icahn who said recently "We can no longer simply depend on the Federal Reserve to keep filling the punch bowl” and while this was likely directed at the ‘Yellen put’ for equity (and asset) markets, we maintain that US monetary policy will turn hawkish, more rapidly than the markets currently expect.