The turnaround in the U.K. economy in 2013 was the envy of the world. The year before, Britain experienced virtually no growth and started 2013 softly but activity began to turn around quickly in the second quarter thanks to the government’s responsive fiscal and monetary policies. From its low in July to its current levels, GBP/USD is up more than 9%. Reflecting the economy’s improvement and the rise in risk appetite, the FTSE climbed to a 13 year high this year while U.K. 10 year bond yields rose more than 100bp to 2.97%. Unfortunately this strength did not translate into a unilateral rally in sterling. While the British pound appreciated significantly against the Japanese Yen and Australian dollar it experienced only small gains against the greenback and New Zealand dollar. Against the euro and Swiss Franc, it lost value which was surprising because the U.K. grew at an annualized pace of 1.9% in Q3 while the Eurozone contracted by 0.4%. Looking ahead, we expect the economy to gain momentum in the coming year but the biggest gains for sterling will not be against the dollar but other major currencies.
3 Main Drivers of U.K. 2014 Growth
3) Global Growth
2014 growth in the U.K. will be driven by housing, banking and a stronger global economy. The U.K. government did a fantastic job of propping up the housing market this year with the Funding for Lending Scheme and the Help to Buy program. Their pledge to keep interest rates low will keep mortgage rates cheap, driving property prices higher and attracting foreign investment in 2014. The U.K. government understands that reflating the housing market is the key to keeping the economy supporting and consumers feeling optimistc. After writing off significant amounts of bad debt, the banking sector is also expected to report stronger earnings and dividends in the coming year. A stronger global environment will solidify the recovery and help the U.K. economy reach the Bank of England’s 2.8% growth target for 2014, which is significantly higher than the 1.6% growth expected for 2013. However there are areas of concern – slow growth in Europe will limit demand within the region and the high unemployment rate could curtail consumer spending. As such, the BoE will tread carefully in the coming year, leaving stimulus in place for as long as possible. Scotland also has an independence referendum in 2014 but we don’t see this as a risk for sterling because the Scots will vote to stay in the union.
Bank of England Has Tough Decision to Make in 2014
– Acknowledge improvements in economy or Lower the Unemployment Rate Threshold
Under the leadership of Mark Carney, the brand new central bank Governor, the Bank of England initiated a policy of forward guidance to hold rates down. This revolutionary policy was introduced in other parts of the world but the U.K. version has met with sharp criticism because the central bank underestimated the strength of the labor market. In August, the BoE believed that the unemployment rate would fall to their 7% unemployment rate threshold by the second half of 2016 but last month they accelerated this forecast by a year to Q3 of 2015. The unemployment rate is now only 0.4 percentage points away from this threshold and it could easily be reached by the middle of 2014. While the central bank has made it clear that 7% unemployment is a threshold and not a trigger for a rate hike, the rapid decline in jobless rate has encouraged investors to position for earlier tightening by the BoE.
Come February when the next BoE Inflation Report and economic projections are scheduled for release, policymakers have a very important decision to make and two of the things they will consider include pulling forward their unemployment rate forecasts and/or lowering the threshold to 6.5%. The key lies in the wage growth. Right now wage growth is lagging behind inflation but if it starts to accelerate, the Bank of England will feel more pressure to raise interest rates. Unlike the Fed whose first step is to reduce asset purchases, the BoE has made it clear that their first move will be a rate hike. The U.K. curve is currently pricing in 50bp of tightening by the end of 2015. If economic data continues to improve and wage growth rises, investors will be looking for an even earlier move.
As shown in the chart below, between January and November, the GBP/USD (white line) took its cue from the differential between U.K. and U.S. 10 year rates (orange line). The correlation broke down in January with the yield spread falling (because of higher U.S. rates) and the GBP/USD rising. In the near term this suggests that a correction in the GBP/USD is likely which is consistent with our view that the best opportunities to buy sterling is against the EUR, JPY and AUD and not the USD.
GBP – Trade the Crosses, GBP/USD Held Back by Fed Tapering
– EUR/GBP to 80 cents
– GBP/JPY to 175 Early 2014
– GBP/USD 1.67/1.60 Range
Between the outperformance of the U.K. economy versus the Eurozone economy and the divergence in BoE/ECB monetary policy direction, we expect EUR/GBP to test 80 cents in the coming year. While the key support level for the pair is the 2012 swing low of 0.7756, we don’t expect this level to be tested unless the Bank of England raises rates in 2014 (which is very unlikely) or the ECB cuts rates to negative levels (possible but not probable). Buying GBP/JPY on the other hand is both a U.S. recovery and global growth trade. Short-term resistance is at 175 but the more significant resistance level is 180. Finally, with the BoE holding monetary policy steady as the Fed tapers, higher U.S. rates should lend support to the greenback, offsetting demand for sterling. This means we expect GBP/USD to trade in a 1.67 to 1.60 trading range in the coming year.