Fundamental Analysis GBP: UK Economic Rebound Fuels Rate Hike Bets, But Election Uncertainty Looms
GBP: Snap Election Clouds BoE Outlook, Traders Eye June Inflation Data
Sunday, 2 June 2024, Week 22: This report analyses the market fundamentals affecting the British pound (GBP), examining fiscal policy, economic indicators, and monetary policy developments. It delves into the factors that have influenced GBP movements over the past five months and five weeks, and assesses the potential influences on the currency in the coming five months and five weeks. The report concludes with a summary of key findings and a list of referenced sources.
The UK economy exited recession in Q1 2024, with GDP expanding by 0.6%, exceeding market expectations. However, the surprise announcement of a snap general election for July 4th has injected political uncertainty into the outlook, potentially impacting the Bank of England's (BoE) monetary policy decisions. While inflation has eased, it remains above the BoE's 2% target, and the labour market shows mixed signals with rising unemployment but continued wage growth. Traders are closely watching upcoming economic data, particularly the June inflation report, for clues on the BoE's next move.
FISCAL POLICY
The UK's fiscal policy remains focused on achieving a primary surplus by 2028-29, as outlined in the Office for Budget Responsibility's (OBR) March 2024 Economic and Fiscal Outlook (EFO). The government's strategy relies on rising tax revenues and controlled spending to stabilise and eventually reduce the debt-to-GDP ratio. However, the EFO acknowledges significant uncertainty surrounding the fiscal outlook, particularly given the volatile global landscape. Key risks include the potential for higher inflation and interest rates, as well as uncertainty surrounding productivity growth and net migration.
Since the November 2023 forecast, the government has loosened fiscal policy by 0.3% of GDP per year, on average, over the next five years. This decision was made in response to a 0.1% improvement in the underlying pre-measures fiscal outlook. This continues a pattern of expansionary fiscal policy observed in recent years, with only two instances of fiscal tightening since December 2014.
The UK's government debt to GDP ratio reached 97.60% in 2023, exceeding the historical average. The March 2024 EFO projects the ratio to peak at 93.2% in 2027-28 before falling slightly to 92.9% in 2028-29. Achieving this projected decline hinges on the government's ability to achieve and maintain a primary surplus, as well as favourable economic conditions. However, the likelihood of achieving this projected decline is subject to significant uncertainty. The OBR estimates a 54% probability that the fiscal target of a falling debt-to-GDP ratio will be met, a slight decrease from the 56% probability estimated in the November forecast.
ECONOMY
The UK economy has shown mixed signals over the past five months. While the economy exited recession in Q1 2024, with GDP expanding by 0.6%, exceeding market expectations of 0.4% growth, other indicators suggest a more fragile recovery.
The labour market presents a mixed picture. The unemployment rate rose to 4.3% in January to March 2024, the highest reading since May to July 2023. The economic inactivity rate also increased, reflecting a growing number of people outside the workforce. However, wage growth remains robust, with average regular pay excluding bonuses increasing by 6.0% year-on-year in January to March 2024.
Inflation has continued to ease in recent months, reaching its lowest level in over two years. The annual inflation rate, as measured by the Consumer Prices Index (CPI), eased to 2.3% in April 2024, down from 3.2% in March and slightly below market forecasts of 2.1%. This easing in inflationary pressures is primarily attributed to falling energy prices. However, core inflation, which excludes volatile energy and food prices, remains elevated, suggesting that underlying inflationary pressures persist.
The UK's trade deficit has narrowed in recent months, driven by falling imports. This narrowing of the trade deficit is a positive development for the UK economy, as it suggests a reduction in the country's reliance on foreign goods and services. However, both imports and exports have fallen in recent months, indicating a potential slowdown in global trade.
MONETARY POLICY
The Bank of England's Monetary Policy Committee (MPC) voted to maintain the Bank Rate at 5.25% in its May meeting, with two members dissenting and preferring a 0.25 percentage point reduction. The decision to hold rates steady reflects the MPC's assessment that, while headline CPI inflation has fallen, underlying inflationary pressures remain elevated.
The MPC acknowledges that the restrictive stance of monetary policy is weighing on economic activity, leading to a looser labour market and bearing down on inflationary pressures. However, the MPC judges that the labour market remains relatively tight by historical standards. The MPC expects wage growth to continue to moderate over the course of the year, as the labour market loosens further and CPI inflation eases.
The MPC remains vigilant about the risks to the inflation outlook, particularly from potential second-round effects in domestic prices and wages. The MPC also acknowledges upside risks to the near-term inflation outlook from geopolitical factors.
The MPC remains committed to its 2% inflation target and is prepared to adjust monetary policy as warranted by economic data. The MPC will continue to monitor closely indications of persistent inflationary pressures and resilience in the economy as a whole.
LOOKING-BACK
Five-Month Influences: Over the past five months, the GBP has experienced a period of appreciation against the USD. This can be attributed to a combination of factors, including:
Shifting Interest Rate Differentials: The BoE's consistent rate hikes throughout the period, coupled with the Fed's recent pause, have widened the interest rate differential between the UK and the US, making the GBP more attractive to yield-seeking investors.
Easing UK Inflation Concerns: While UK inflation remains above the BoE's target, its consistent decline over the past five months has eased concerns about runaway inflation, supporting the GBP.
Improving UK Economic Outlook: The UK economy's exit from recession in Q1 2024, with stronger-than-expected GDP growth, has boosted confidence in the UK's economic recovery, further supporting the GBP.
Five-Week Influences: In the past five weeks, the GBP has experienced some volatility, with the announcement of a snap general election in July creating uncertainty and weighing on the currency. Key influences include:
Snap Election Announcement: Prime Minister Sunak's announcement of a snap general election for July 4th has injected political uncertainty into the UK, potentially impacting the BoE's monetary policy decisions. Markets now anticipate the BoE's first rate cut to occur in September rather than June, as the central bank might want to avoid being seen as influencing the election outcome. This has led to a weakening of the GBP in recent weeks.
Mixed UK Economic Data: The latest UK economic data has been mixed, with positive GDP growth offset by rising unemployment and a widening trade deficit. This mixed data has contributed to the GBP's recent volatility.
Global Risk Appetite: Geopolitical events, such as the ongoing war in Ukraine and tensions between China and Taiwan, have influenced global risk appetite. Periods of heightened risk aversion have generally supported the USD as a safe-haven currency, putting downward pressure on the GBP.
LATEST and LOOKING-AHEAD
Five-Month Potential Influences: Looking ahead, the GBP's trajectory will likely be influenced by:
UK Election Outcome: The outcome of the July 4th general election will be a major driver for the GBP. A Conservative victory could provide some certainty and support for the currency, while a Labour victory could lead to uncertainty about future economic policies and weigh on the GBP.
BoE Monetary Policy: The BoE's future policy decisions will be crucial for the GBP. If the BoE maintains its hawkish stance and continues to raise interest rates, the GBP could strengthen. However, if the BoE signals a pause or pivot in its policy, the GBP could weaken.
UK Economic Performance: The health of the UK economy will also be a key driver for the GBP. Strong economic growth could support the GBP, while a further slowdown could weigh on the currency.
Five-Week Potential Influences: In the next five weeks, the GBP could be influenced by:
June Inflation Data: The release of the UK CPI inflation data for May, due on Wednesday, June 19th, will be a key data point for assessing inflationary pressures and could influence BoE policy expectations and the GBP. A higher-than-expected inflation reading could support the GBP, while a lower-than-expected reading could weigh on the currency.
BoE Communication: Any speeches or statements from BoE officials in the coming weeks could provide clues about the central bank's thinking on interest rates and the economy, potentially impacting the GBP.
Global Risk Appetite: Geopolitical events and global economic conditions will continue to influence risk appetite. If risk aversion increases, the USD could benefit from its safe-haven status, putting downward pressure on the GBP. However, if risk appetite improves, the GBP could strengthen as investors seek higher-yielding assets.
CONCLUSION
The GBP is currently facing a confluence of factors that are contributing to its mixed performance. While the UK's economic recovery and the BoE's hawkish stance provide some support for the currency, political uncertainty surrounding the upcoming general election and concerns about the global economic outlook are weighing on the GBP.
Looking ahead, the GBP's trajectory will depend on the outcome of the UK election, the BoE's policy decisions, the performance of the UK economy, and global risk appetite. Key events in the coming weeks, such as the release of the UK CPI inflation data for May and the BoE's June interest rate decision, could trigger significant volatility in the GBP.
Referenced Sources:
Office for National Statistics (ONS)
Trading Economics
Bank of England
Office for Budget Responsibility (OBR)