U.K. GDP Shock Dents Pound Sterling Outlook, but too Early to "Throw in the Towel" on Positive Outlook says one Analyst

- UK economy is slowing, and snow can't take all the blame

- Pound plummets as markets bet Bank of England interest rate in May is off the table

- Strategists at TD Securities exit bet on Sterling appreciation

- ING suggest a June hike is now a possibility, say "too early to throw in the towel"

Image © IRStone, Adobe Stock

The British Pound has sold off sharply and analysts agree the outlook for the currency has soured following the release of economic growth data for the first three months of 2018 from the Office for National Statistics.

GDP data shows the economy grew just 0.1% in the first quarter, below analyst forecasts for growth of 0.3% representing the slowest pace of growth since the fourth quarter of 2012.

Crucially, the ONS reported that the decline in UK economic growth cannot be laid solely at the door of the poor weather suffered in March saying; "while some impacts on GDP from the snow in the first quarter of 2018 have been recorded for construction and retail sales, the effects were generally small, with very little impact observed in other areas of the economy."

This hints at a broader slowdown in economic activity and markets are betting that a May interest rate rise at the Bank of England is now off the table.

"May is likely off the agenda now for the BoE," says Neil Jones at Mizuho Bank Ltd. "GBP sells off hard."

Jones notes the 0.1% GDP reading goes beyond "the beast from the east" narrative and "suggests the slowdown is more structural."

Currency markets are pricing in this eventuality with the Pound-to-Euro exchange rate ending the week at 1.1340 having opened the day at 1.1493.

The Pound-to-Dollar exchange rate is now down at 1.3780, having started the day at 1.3917.

Above: The Pound-Dollar exchange rate falls sharply in the minutes following the UK GDP release

"It has been a grim two weeks for the Pound with stagnant wage growth, weak retail data and now a big miss on GDP for the ,first quarter helping to push it down over 4% versus the USD. With Brexit coming into focus next week over the customs union debate the Pound is likely to face further short term headwinds," says Phil McHugh, Chief Market Analyst at Currencies Direct.

"The chance of a May rate hike is now close to zero following the slowdown in GDP growth in Q1," says Samuel Tombs, Chief UK Economist with Pantheon Macroeconomics.

Looking ahead, Pantheon Economics believe GDP growth will likely recover back to the 0.3%-0.4% rates seen last year as households’ real incomes are now recovering and, at the margin, the recently-agreed Brexit transition deal should make some firms more confident to invest.

"But with inflation falling much more rapidly back to its target than the MPC expected and wage growth still not building momentum, the MPC has the luxury of being able to delay raising interest rates in May to be sure that the Q1 slowdown was largely a weather-related blip," says Tombs.

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The Details

According to the ONS, UK gross domestic product (GDP) was estimated to have increased by 0.1% in Quarter 1 (Jan to Mar) 2018, compared with 0.4% in Quarter 4 (Oct to Dec) 2017.

UK GDP growth was the slowest since Quarter 4 2012, with construction being the largest downward pull on GDP, falling by 3.3%. Note that construction activity was already under significant pressure ahead of the cold snap suffered in March.

Production increased by 0.7%, with manufacturing growth slowing to 0.2%; slowing manufacturing was partially offset by an increase in energy production due to the below-average temperatures.

The services industries were the largest contributor to GDP growth, increasing by 0.3% in Quarter 1 2018, although the longer-term trend continues to show a weakening in services growth.

Whilst GDP growth is always an important indicator for Pound Sterling, today's figures may draw even more attention than usual owing to increasing doubts about whether the BoE will, in fact, go ahead and raise interest rates at its May meeting or not.

Expectations were in the 90% probability zone before the disappointing mid-April batch of data releases with wage growth and retail sales all suggesting the economy to be losing momentum, while softer-than-forecast inflation data suggested the squeeze on prices was becoming less of an headache for the BoE.

The slowing economic momentum is noted by the Bank of England. Rate rise expectations fell into the 50% range following comments from Bank of England Governor Carney in which he said, "there are other meetings over the course of this year," markets interpreted this as being suggestive interest rates could be raised at a later meeting, if not in May.

This triggered a broad-based sell-off in the Pound, the move being confirmed as justified by the latest official data.

"In the wake of cautious comments from Governor Carney, a very weak Q1 GDP print has ended the chances of a rate hike in May. For us, it means no hike at all in 2018," says a note from UBS, warning that a former source of GBP support might be off limits for the remainder of the the year.

Where Next for the Pound?

Ahead of the release we reported a GDP growth result of 0.1% or lower would materially impact the outlook for the May rate meeting.

According to analysis from TD Securities, a disappointing result of 0.1% or lower could see the Pound-Euro pair probe 1.1213 (D) but downside might be limited by the fact that some negativity is already baked into the exchange rate following Carney's comments.

Separately, Ned Rumpeltin, European Head of FX Strategy at TD Securities, announces in the wake of the ongoing Sterling sell-off he is closing a short EUR/GBP position in the bank's FX model portfolio.

"We opened this position on a spot reference of 0.8750. Our initial target was a move down to 0.8350 with a stop at 0.9025. We have closed this position on a spot reference of 0.8731, essentially breaking even on the trade," says Rumpletin.

The softer-than-expected Q1 GDP report has added to market doubts the Bank of England will be able to hike at its May meeting notes Rumpletin.

"These doubts have grown in the wake of dovish comments from Governor Carney last week. While it seems unlikely Carney would discuss the monetary policy decision for May at today's 3pm event which is geared as an educational function, there is a risk and we think it is prudent to exit this position at this time," says the analyst.

Viraj Patel, a foreign exchange strategist with ING Bank N.V. says UK GDP at 0.1% sees odds of a May Bank of England interest rate hike slashed further.

Patel says the BoE will be brave to hike in May, but the move still can't be ruled out.

"GBP/USD at 1.38 is consistent with a no May BoE rate hike scenario. Flat UK curve suggests we've already had the dovish re-appraisal. Hard to see GBP weakening further on a dovish BoE story. P.S. There is a June meeting... the BoE could tee up a non-press conference hike," says Patel.

ING believe acknowledge there is a temptation to say that "this is as good as it gets for the Pound," but, "we think it may be too early to throw in the towel on our bullish GBP outlook; one set of data releases do not alter a medium-term outlook, while the forces that have underpinned a more buoyant GBP in 2018 - namely a re-pricing of a structural Brexit risk premium and lower short-term economic uncertainty - still to some degree remains in place."

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