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View: Economic weakness more of a risk for GBP than Gilts, like duration
The timing of Nigel Lawson’s observation that George Osborne should relinquish his role as chief Conservative chief party strategist to focus on the more important role of Chancellor has proved to be rather well timed with this morning’s first look at Q2 GDP showing the UK economy shrank at a dire -0.7% q/q rate, well below the median forecast of -0.3% q/q, leaving y/y growth at -0.8%. Ouch. The market was quick to seize on the positives, citing the Jubilee effect which most seem to think knocked 0.5% of the quarterly growth reading not to mention the rain which lasted a lot longer than that extended weekend. But this doesn’t alter the fact that the reading missed the median guess (who knew about the bank holiday and might have also looked out of the window at some point in Q2) by a significant margin and leaves us with three consecutive quarters of contraction in this double dip.
Full report below…
View: GBP/USD should struggle beyond 1.6100/40, watch for signs of a reversal
Sterling’s climb from the lows sub GBP/USD1.5300 touched at the start of the month has been quite impressive, the unit holding just under the 1.6000 level currently. Unfortunately this hasn’t been due to any particularly positive UK developments, rather the recovery has been on the coattails of a resurgent euro as investors piled in behind the view that policy makers there finally ‘get it’ and a credible solution was now in the works there. Of course such a scenario is essential for the UK too given that around half the country’s exports head for the single currency zone, but not enough in our view to warrant any substantial re-rating of the pound.
Examining UK dynamics more closely things are looking increasingly tough. Inflation hit 5.2% y/y in September (mkt 4.9%) and although nasty base effects were partly to blame it’s difficult to deny that there is a problem, underlined by rising inflation expectations, even if the headline rate does finally begin to moderate. This might normally be expected to help erode debt, but wage growth is paltry with the fall in living standards well documented and the unemployment rate is rising again, something not lost on the consumer with both the Nationwide (Sep reading 45.0 from 49.0 in Aug) and GfK (-30 vs. -31 in Aug) confidence survey’s stuck in the doldrums. It’s not just consumers though; the PMI’s showed manufacturing slipping into contraction over the summer while construction also continues to weaken. Only services have shown any resilience and the sustainability of that is questionable given income pressures and tightening fiscal policy. This should all be evident next week in the advance Q3 GDP print. Although NIESR estimates 0.4-0.5% growth recent performance and shocks over the summer (weather included) suggest this is optimistic.
Bank of England moves are equally telling, the additional dose of QE (increasing the programme from £200bn to £275bn) accompanied by cautious rhetoric as to the economic outlook, beyond here there have been calls for the government to show flexibility with regard to its fiscal consolidation. This was dismissed out of hand. It is after all the lone source of credibility left in the eyes of the market, even if the pledged budget targets look fantasy with the economy teetering. One metric worth keeping an eye on is the performance of gilts vs. bunds. While German paper outperformed amid flight to quality demand as the debt crisis flared, Deutschland’s credit worthiness is increasingly being called into question based on the assumption that they will have to bear a disproportionate cost of expanded bailouts. If we see UK yields begin to underperform vs. the German curve digesting this risk it might be an ominous sign. For reference 10-year spreads between the two sovereigns are currently +42bps from closer to 60bps at the start of the month.
The currency looks equally exposed, particularly given that economic performance may force the BoE to inject even larger quantities of cash into the economy via its inefficient QE channel. This should weigh on sterling, pressure that would become even more intense if markets begin to question the viability of the fiscal project too. The EUR/GBP chart still looks an uninspiring way to play this; however looking at cable we think the market will struggle to make much headway higher, the GBP/USD1.6100/40 area as really the very top of the recovery rally. Medium-term we continue to believe that GBP/USD should be able to push down through the September lows sub 1.5270 and would keep a close eye on indicators such as the MACD for sell signals. Even those with a more constructive view would be better served by patience, being room for even a short-term correction to tag back to the 1.5785 area if initial daily support at 1.5920/40 fails.
Related articles
- Mervyn King defends QE programme (independent.co.uk)
- Citi On Whether Europe Can Ruin The World; Or How To Use An Insolvent Continent As An Excuse For Global Printing (zerohedge.com)
