Solid Wage Growth Fails to Support Sterling amid Gloomy BoE Outlook

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- UK wages surprise on the upside but GBP slides.

- Jobless rate holds post-1974 low but claimants rise.

- GBP on the blink as market gives up on BoE outlook.

The Pound hit the ropes again Tuesday as the market responded to official employment figures for the month of May, with subsequent price action suggesting investors have all but given hope of seeing the Bank of England (BoE) lift its interest rate anytime soon. 

Unemployment remained at 3.8% in the three months to the end of May, its lowest level since 1974, but the number of new welfare claimants surprised on the upside again with a 38k increase when markets were looking for only 18.9k. The number of vacancies also fell too, continuing the 2019 trend.

However, and on the upside, workers' wage packets grew much faster than was expected, with pay growth including bonuses rising at an annualised rate of 3.4%. That's up from an upwardly-revised 3.2% and above the consensus for a reading of 3.1%. It also means 'real pay growth' of 1.4% for the period. 

"UK wage growth has a hit another post-crisis high as skill shortages continue to bite. There are structural reasons to suggest this trend is unlikely to reverse just yet, but the cyclical story is looking a little less encouraging. We don't expect any change in policy from the Bank of England this year," says James Smith, an economist at ING. 

Above: Sectoral growth in UK wages. Source: ING Group. 

"The labour market is emitting enough upward inflation pressure to dissuade the MPC from cutting interest rates over the coming months," says Sameul Tombs, chief UK economist at Pantheon Macroeconomics. "The latest wage numbers, meanwhile, support the MPC’s view that the 3.8% unemployment rate is below the rate consistent with its inflation target."

Markets care about the labour market data because falling unemployment and improving job creation are thought to put upward pressure on wages. Pay growth leads to increased demand in an economy and upward pressure on inflation, with implications for interest rates and financial markets.

Changes in rates are only normally made in response to movements in inflation, which is sensitive to economic growth, but impact currencies because of the influence they have on capital flows and their allure for short-term speculators.

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

"The MPC is constrained by the medium-term outlook for relatively high inflation; only in the event of a no-deal Brexit or a sustained increase in unemployment above 4% would [it] sign off fresh stimulus," Tombs says. 

Above: Pantheon Macroeconomics graph showing UK wages growth rates.

"October is shaping up to be a very difficult month for UK politics. Our baseline (35-40% probability) sees Boris Johnson named leader of the Conservative party and PM (24 July). When parliament returns in September, futile attempts to renegotiate the Brexit deal with Brussels can see a ‘No Deal’ government base case emerge," says Chris Turner, head of FX strategy at ING. "Early elections (December?) and another Article 50 extension beckon." 

Tombs, whose been ranked by Bloomberg and Reuters as the UK's top inflation forecaster, said last week the falls undergone by Pound Sterling since early May are enough to add 0.3% to Bank of England inflation forecasts for the coming years and UK inflation was already at 1.9% in May. 

The BoE is obliged to use interest rate policy to ensure the consumer price index averages 2% over the medium-term and it's said repeatedly in the years since the Brexit referendum that it thinks interest rates will need to rise sooner or later to had of another likely period of above-target inflation. 

However, the October 31 expiry of the current Article 50 negotiating period is drawing closer and both candidates to replace outgoing Prime Minister Theresa May hinting that they'll use the threat of a 'no deal' Brexit to gain changes to the EU withdrawal agreement that Brussels already claims it won't countenance.

Market perceptions that the likelihood of a 'no deal' exit from the bloc is rising have seen Pound Sterling fall steadily over the last eight weeks and many have tipped the British currency for further losses in the months ahead given the apparent looming negotiating deadlock ahead of October 31. 

The uncertainty about what all this will mean for the already-slowing economy has seen the market go from betting the BoE will lift its interest rate by year-end to looking for a rate cut, which may be why Pound Sterling continued to fall even after Tuesday's wage data was released.

"It is difficult to see a clear trigger which could bring an end to the current weakening trend. We expect the Pound to continue weakening heading into the crunch autumn Brexit period," says Lee Hardman, a currency analyst at MUFG. "There is still scope for speculative short pound positions to increase further which could reinforce downward momentum. After breaking below the 1.2500-level, the door has been opened for cable to potentially retest the lows from late 2016/ early 2017 at around the 1.2000-level." 

Above: Pound-to-Dollar rate at daily intervals alongside Pound-to-Euro rate (orange line, left axis).

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