GBP: The Party Is Over?

by: Evariste Lefeuvre

The British Pound has been appreciating across the board for more than one year now. As can be seen below the upward trend in the nominal effective exchange rate (trade weighted) continued in spite of a deceleration in the economic news flow.

The news flow (or surprise index) is a second order data series: it reflects the difference between published data and expectations. As the economic activity rises, expectations adjust accordingly and it is normal for the index to mean revert. For that reason it could be better to compare it to the change in the spot value of the Pound effective exchange rate. As can be seen on the second chart, the disconnect is also visible.

The disconnect is also visible when we compare the change in the nominal effective exchange rate to the change in the UK Manufacturing PMI). All this could suggest that the GBP has overshot and that in spite of a brighter economic picture than 6 months ago, the upward momentum may soon begin to stall.

This disconnect is taking place at a time when the British Pound is sending significantly positive technical signals. In both charts below (nominal effective exchange rate and cable) the medium run technical resistance has been breached. If this represents a significant regime switch, the retracement could be quite sharp in the first half of 2014. Could any macro forces or events weaken the currency, disrupting the consensus view that the GBP is due to outperform?

Beyond the economic performance, the main driver of the British pound exchange rate for the next quarters will definitely depend on relative monetary policies. The Bank of England (BOE) is currently seen as the most hawkish central bank, in comparison with the ECB and the BOJ - the only serious rival being the Fed.

Thresholds or triggers linked to the unemployment rate are at the core of the forward guidance for both the Fed and the BOE. For the latter, the 7% unemployment rate is associated to the end of both quantitative easing (375 b GBP program) and ZIRP (actually 0.5%).

In the US the 6.5% threshold is associated with the sole traditional monetary policy tool (Fed funds). In both cases, central banks across the pond managed to dismiss the importance of the threshold, the Fed in particular, for which "it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal". The BOE for its part has clearly indicated that no rate hike would occur in 2014.

But the question, for both central banks lingers in the 2015/2016 area. The first chart below (left) clearly shows the big difference between the Fed/BOE exit pressure and the ECB whose late implementation of the forward guidance has helped keep the short end yield curve rather flat. The right hand chart also shows that the cable has clearly been driven by the 2015/2016 tenor of the money market curve.

For the upward momentum of GBP crosses to continue, the BOE will have to provide a significant reason to tighten earlier and more aggressively than the Fed. That's where the productivity conundrum comes into play. Even if unemployment thresholds are breached it far from certain that wages will accelerate from those levels. Both charts below show the link between productivity and real wages.

i. In the US, productivity gains are declining which led Ben Bernanke to add it to "the list of reasons that economic growth has been slower than hoped". Yet, in spite of a distribution of income skewed towards profits, real wages have managed to rise, albeit modestly, over the last few years.

ii. In the UK though, not only have productivity gains been negative on average since the Great Recession but real wages have also declined. The fall in the unemployment rate is skewed by highly flexible contracts (zero hour) and does not come along with any improvement of households' wages. Given that more than 70% of all mortgages are based on adjustable rates, the BOE will need more catch up in wages to be willing to tighten.

This macro picture clearly highlights that the risk for a central bank to be behind the curve is clearly on the US than on the UK side if the recent trends continue: cost-pushed inflation emerges when productivity growth falls behind real wage growth. Said differently and referring to the charts above, the UK money market curve may have steepened too much on the 2015/2016 tenors.

Bottom Line: while balance sheet growth differential drove markets and FX pairs during the last few years, 2014 will likely be driven by rate divergences, which are highly dependent on the cyclical position of economies. Given the recent trend in the news flow and PMI and the lackluster trend in productivity (and hence wage) growth in the UK, I would clearly call for a stop in the overall appreciation of the GBP. Not only would the MM curves expected trajectories call for it but also the fact that the disconnect between the spread of the news flow in both US and UK cannot justify the current level of the GBP/USD.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.