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GBP risks still to the downside despite Bank of England's interest rate hike

Publication Date: 02 Aug 2018 - By Adrian Schmidt By Adrian Schmidt
Actionable
Differentiated

Macro FX & Rates Fixed Income/Credit FX UK

The Bank of England rate rise to 0.75% was widely anticipated and the only surprise was that the decision was unanimous – most had expected an 8-1 vote. Sterling initially rallied slightly on the news but failed to sustain gains and looks like finishing lower on the day.

In practice, there was very little that was surprising about the move. It had been well flagged by the Bank and the decent UK data this year has justified some reduction in monetary accommodation.

However, part of the reason for higher rates is that the Bank of England sees weaker potential UK output rather than stronger expected output, so that moderate demand growth is expected to outpace somewhat sluggish supply growth. This is less of a positive for the currency than a combination of strong supply and stronger demand.

However, the elephant in the room is the uncertainty surrounding Brexit. The Bank of England is assuming a “smooth” transition, which, given the current state of political negotiations both within the UK and between the UK and the EU has to be seen as an optimistic view. Even on this view, UK growth performance is not expected to outperform any of the major countries. The risks therefore look to be primarily on the downside for growth, and consequently for GBP

Two observations underline the risks for GBP. First, even after this rate hike the REAL UK policy rate is still low by G5 standards. Real rates are now a little above the Eurozone, but still below the US, Canada and even Japan. Second, despite the decline in GBP since the Brexit referendum, there seems little reason to believe that GBP is undervalued. GBP is still below PPP against the EUR and JPY, and close to PPP against the USD.

The UK still runs a significant current account deficit. So given the Brexit risks, the risks to GBP still look to be on the downside. A smooth transition to Brexit might allow GBP to rally a little, but longer term it looks unlikely to settle far above current levels.

Not much is likely to happen Brexit-wise until the EU Summit in October, but ahead of that the risks may be more global due to the burgeoning trade war between the US and China (and others).

Risk negative news is likely to weigh on GBP given the UK’s current account deficit and the problems of Brexit uncertainty already limiting the UK’s attraction as a destination of foreign investment. So the risks for GBP still seem primarily on the downside. 

GBP/JPY looks the most attractive pair to express downside risks.

 

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