Pound Sterling to Find Strength from BoE but will Still End Year Lower Against Euro and Dollar say BAML

Pound Sterling's run higher could extend in the near-term say Bank of America Merrill Lynch who however warn the bounce is temporary and reiterate their forecast for the currency to end 2017 at lower levels against both the Euro and Dollar. 

Tuesday’s inflation data which put the consumer price index at 2.9% and nearly 100 basis points above expecations, gave market-wide expectations for a Bank of England interest rate rise a nudge forward, in turn prompting a sharp rally in Sterling-based currency pairs.

The Overnight Index Swaps market has now gives a greater probability of a rate hike from the Bank by year-end, implying a 30% chance of a hike in December, this compares with 20% a week ago.

"We expect a more hawkish BoE statement after Thursday's policy meeting on signs of life in wages and Sterling's fall," says Robert Wood, an economist at Bank of America Merrill Lynch in London.

A "more hawkish" assesment of the Bank of England implies a positive outcome for the Pound.

“That is not to say the UK economy is doing well. Growth is underwhelming and risks high. But growth seems to be beating BoE expectations and most importantly wage growth shows some signs of life,” says Wood.

Indeed, Bank of America believe a December rate hike is unlikely, which in turn suggests Sterling's rally is a ultimately unwarranted.

"We are making a point about words not deeds and risks not central case… We still expect weak growth to prevent hikes until 2019 at least,” adds the economist.

Thursday Presents Asymmetric Risks for Sterling

With the Pound having risen against both the Dollar and Euro through August, what could the potential outcome of the Bank’s Thursday meeting be?

Bank of America Merrill Lynch Global Research reckon the risks are asymmetric.

“Given the significant adjustment that took place in GBP in the aftermath of the EU Referendum, triggered by downward revisions to the UK growth profile, we continue to believe that bad news on the economy is unlikely to mean bad news for Sterling,” says BAML’s Kamal Sharma.

BAML’s view is premised on the belief that while markets have been willing to price in rate hikes in response to data and BoE rhetoric, they have been less willing to price in rate cuts as the economy has slowed.

Though UK rate hike expectations have been pushed back into 2019, markets have been reluctant to price in further easing.

“As a result, a less dovish MPC is likely to provide some support for GBP,” says Sharma.

But any strength is likely to be a short-term phenomenon and BAML reiterate their call for a weaker GBP based on progress regarding Brexit. 

A series of political events are expected to test the market's belief that a transition agreement will be announced sooner rather than later.

So it could be a case of the Pound bouncing further on the September Bank of England event, only to ultimately give back gains as the longer-term downtrend reasserts as markets return focus to Brexit politics.

As such, BAML are forecasting the Pound-to-Dollar exchange rate to end 2017 at 1.25, and end 2018 at 1.27.

The Euro-to-Pound Sterling exchange rate is forecast to end 2017 at 0.92 and end 2018 at 0.94.

This gives us a Pound-to-Euro rate at 1.09 and 1.06.

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UK Employment Data Presents Quandry for Bank of England

Capping Sterling's gains mid-week is the release of labour market data from the Office for National Statistics.

The data confirmed the UK economy continues to offer more jobs with the unemployment rate dipping down to 4.3%.

But Pound Sterling eased off recent highs on news that UK wage growth read at 2.1% in July, unchanged on the previous month's figure.

Markets had forecast 2.3% growth, and it is because of this miss on expectations that the Pound has edged lower.

With wage growth at 2.3%, and inflation at 2.9%, it is clear the average citizen is getting poorer.

This will have a knock-on effect on spending elsewhere in the economy and might help explain why the UK's economic growth rate has come off the boil in 2017.

"While the continued strength of employment will be welcomed by the MPC, the continued absence of a pick-up in wage growth is likely to keep the doves in the majority. And with inflation reaching 2.9% in August, the squeeze on households’ real incomes probably intensified. That would make the risk of a sharper downturn in consumer spending the overwhelming concern to the majority of the MPC members," says Andrew Wishart, UK Economist at Capital Economics.

On one hand wages are not showing signs of lift-off, while on the other employment is growing at a decent clip and underscores the resillience of the economy.

Boosting the argument for a potential interest rate rise at the Bank of England is news that the unemployment rate is now below the Bank of England’s estimate of the equilibrium rate to 4.3%, down from 4.4% in the three months to June.

The equilibrium rate is the level beyond which further falls generate notable increases in employment, the thinking going that labour becomes increasingly scarce and companies must therefore pay more.

Thus, the story of wage rises could be one that characterises coming months. If the Bank of England shares this view, Sterling should move higher as it suggests the Bank is confident it can start fighting inflation while not jeopardising economic growth.

"With the unemployment rate moving down to 4.3% - much sooner than the Bank of England envisaged - and below the MPC’s estimate of the ‘equilibrium’ unemployment rate (4.5%), the pressure on the BoE to reassess their views on the labour market will continue to build," says Nikesh Sawjani, UK Economist at Lloyds Bank.

As inflation rises further, Sawkani believes workers may yet become more assertive in their wage demands to resist the depletion of their purchasing power.