Pound / Euro Recovery Remains Fragile Near-Term, Longer-Term Outlook Bright

Updated: 14 August 2015

The British pound is struggling to defend a key support level against the euro on shifts in interest rate expectations in the UK.

"We have shifted our call for the start of UK policy tightening from November to February next year." - Lloyds Bank. 

Heading into the weekend the pound sterling is managing to hold the 1.40 pavement against the euro, something that must be achieved if a slump towards 1.36 next is to be avoided.

Only if this zone is held can the prospect of a sustained recovery towards the 2015 best exchange rate above 1.44 remain possible.

The latest decline in GBP comes as markets start to bet that the US Federal Reserve and the UK’s Bank of England will delay their first interest rate rises on observations that Chinese Yuan devaluations are a warning on slowing global growth.

We note that the US Fed’s Fischer has already prompted analysts to begin doubting the market's scheduled September lift-off at the US Fed even before events out of China.

With China signalling a shift in global currency dynamics and heralding a potential global growth slowdown the US Fed may have the perfect excuse to stick to their easing bias and delay that pro-USD interest rate rise in September.

The Bank of England will only raise rates following the US Fed as per historical example, thus the BoE is also seen delaying.

We believe that a delay in the US Fed interest rate rise is ultimately a neutral for the pound to dollar exchange rate but against the euro the prospect for declines is greatest - and this is why we are seeing EUR/USD and EUR/GBP rally.

Lloyds Push Back Date on First Rate Rise

Almost on cue, in their monthly International Financial Outlook summary of forecasts, Lloyds Bank have on Thursday advised they have pushed back their predicted date for the first rate hike to February.

"We have shifted our call for the start of UK policy tightening from November to February next year. The risks around this are asymmetric: the first move could come later if the global outlook continues to deteriorate and near term inflation pressures continue to fade," say Lloyds.

This could be exactly what other analysts and broader money markets are thinking.

Recent Chinese turmoil, which has put downward pressure on commodity prices – and by extension future inflation – has influenced market thinking.

The surprisingly weak numbers for domestic wage inflation in Q2 and a slowing pace of decline in unemployment, which were evident in the latest labour market statistics, also played a role. However, this is to miss the point.

Fundamental Outlook is Bright and Rises in the Exchange Rate and Interest Rates Will Come

We have heard that Goldman Sachs is not shying away from their bullish forecasts on both the pound and the dollar with gains of 20 pct being forecast for the USD index and 12% for the GBP basket.

Underlying this bullish viewpoint is the fundamental picture within which the US and UK economies are performing at a rate that warrants higher interest rates.

Higher interest rates = a higher exchange rate.

Much-watched jobs data out of the UK in August saw employment tick up in the previous month while earnings come in at 2.4% growth, just below predictions for 2.8%.

Nevertheless, the outlook is undeniably firm with the Institute of Directors saying the latest employment and wage statistics represents a new phase of the recovery.

“With job security on the rise and wages continuing to grow ahead of inflation. After years when preserving – and then creating – jobs was the main priority, businesses are now rewarding employees who cut down on hours or accepted pay freezes with extra work and higher wages.  The slight decrease in the overall number of people in work is a natural part of this transition from a fragile recovery to a strong, growing economy,” says Michael Martins, Economic Analyst at the Institute of Directors.

The IoD say confidence should remain high for the foreseeable future, with ‘lowflation’, strong growth and a tightening labour market on the horizon.

“The signs are encouraging here too, as figures suggest output per hour could be growing at its fastest rate for a number of years,” says Martins.

So while interest rate rises may be delayed they will have to come and we remain bullish on the longer-term prospects of the GBP.

Commerzbank: The BoE Must Act

Commerzbank's Peter Dixon meanwhile argues that the Bank of England is playing a dangerous game by keeping rates at unjustifiably low levels.

"So far, the debate has been framed in terms of changes in rates but there is increasingly an argument to suggest that it is the level of rates which is important, and that they are too low relative to current conditions," says Dixon.

"Whilst low rates have helped the real economy to recover, they have introduced distortions into asset prices – notably housing – and the longer rates are held at current levels, the more pronounced these distortions will become."