GBP: Facing Headwinds

Fundamental Analysis of the GBP

Saturday, 25 May 2024 Week 21: This report provides a comprehensive analysis of the fundamental factors influencing the British pound (GBP), drawing upon recent economic indicators, fiscal policy announcements, and monetary policy statements from official UK government sources. The report is structured to offer a clear and concise overview of the UK's economic landscape, focusing on its potential impact on the GBP, particularly against the US dollar (USD). The analysis is tailored for Forex traders seeking to understand the short-to-medium term outlook for the GBP and inform their trading strategies.

The GBP is facing headwinds over the next five weeks due to a confluence of factors, including heightened political uncertainty surrounding the upcoming general election, softening economic data, and the potential for further Bank of England (BoE) monetary policy tightening. These factors suggest a potential depreciation of the GBP against the USD, with a possible trading range between 1.245 and 1.285. This outlook aligns with Trading Economics' forecast, which anticipates GBP/USD trading at 1.26 by the end of this quarter.

GEOPOLITICS and RISK TOLERANCE IN U.K. MARKETS

Several geopolitical and economic risk factors are influencing the UK markets, potentially impacting the GBP:

• Shifting Fed Rate Cut Expectations: The expectation of an immediate Fed rate cut has diminished, leading to a strengthening of the US dollar, which puts downward pressure on GBP/USD.

• UK General Election Announcement: The snap general election announced for July 4th has introduced significant political risk. With polls favouring the Labour party, markets are pricing in the potential for increased volatility in UK assets, including the pound sterling. Uncertainty surrounding Labour's economic policies could weigh on investor sentiment.

• Worsening UK Retail Sales Data: April's UK retail sales data significantly underperformed expectations, declining by 2.3%. This weak reading has amplified concerns about the health of the UK consumer and the broader economic outlook, adding to the pressure on the pound sterling.

• US-China Tensions over Taiwan: The inauguration of Taiwan's new president is expected to be a catalyst for increased US-China tensions. This escalating geopolitical rivalry is a risk factor for global markets, potentially impacting investor confidence and disrupting supply chains, which could indirectly weigh on the GBP.

U.K. FISCAL POLICY

The UK's fiscal outlook is characterised by stagnating output and declining but still elevated inflation. The Office for Budget Responsibility (OBR) has highlighted the substantial uncertainty surrounding this outlook and points to various risks that could significantly impact public finances.

The OBR's assessment that the government will need to run a primary surplus of 1.3% of GDP to stabilise debt in the medium term is a key takeaway for Forex traders. This challenging fiscal backdrop stems from high debt levels, subdued economic growth, and elevated interest rates.

The Spring Budget's front-loaded package of measures, including substantial net tax cuts, is expected to increase borrowing by £12.7 billion in 2024-25. This fiscal loosening is likely to have a mixed impact on markets, potentially boosting short-term growth but also increasing inflationary pressures.

The outlook for UK Public Sector Net Debt to GDP remains challenging. The OBR's central forecast suggests that the government's fiscal policy will be sufficient to stabilise and then reduce debt as a share of GDP by 2028-29. However, the small headroom against the fiscal mandate, coupled with numerous risks to the forecast, suggests this outcome is far from guaranteed.

U.K. ECONOMY

The UK economy has emerged from a technical recession in Q1 2024, with GDP growth exceeding expectations at 0.6%. However, the underlying fiscal situation remains a concern, with the OBR highlighting the challenge of stabilising debt.

The labour market presents a mixed picture. Positive indicators include annual growth in payrolled employees and consistently strong wage growth exceeding inflation. However, rising unemployment and a continued decline in vacancies suggest potential underlying weakness.

Inflation continues to ease in the UK, with CPIH dropping to 3.0% in April 2024 and CPI falling to 2.3%. The decline is primarily attributed to falling energy prices. However, counteracting this positive trend, OOH costs have continued to rise.

The UK's trade deficit has narrowed for the third consecutive month, reaching £1.098 billion in March 2024. This positive trend is attributed to falling imports, driven by a decline in goods purchased from the EU. However, both imports and exports fell in March, reaching six-month lows.

MONETARY POLICY

The BoE has maintained its Bank Rate at 5.25% in its last six MPC meetings. This decision comes as the BoE anticipates inflation to return to close to the 2% target in the near term. However, a slight increase to around 2.5% is expected in the second half of 2024.

The MPC minutes reveal a 7-2 vote in favour of maintaining the current rate, with two members voting for a 0.25 percentage point cut. This suggests a general consensus within the committee on the current policy stance, albeit with a growing minority expressing concerns about the potential impact of high interest rates on economic growth.

The BoE's decision to hold rates steady is supported by the latest economic data, which indicates that inflation is moderating, albeit at a slower pace than initially anticipated. The BoE's forecasts suggest that inflation is likely to remain above the 2% target for a prolonged period, raising concerns about the potential for second-round effects on inflation expectations.

CONCLUSION

The GBP faces a confluence of challenges in the coming weeks, stemming from political uncertainty surrounding the upcoming general election, softening economic data, and the potential for further BoE monetary policy tightening. These factors suggest a potential depreciation of the GBP against the USD, with a possible trading range between 1.24 and 1.28.

Traders should closely monitor upcoming economic data releases, particularly those related to inflation, GDP growth, and the labour market, for further clues on the BoE's policy trajectory. Additionally, political developments leading up to the general election will be crucial in assessing the potential impact on the GBP.