I have decided to write a follow up to my previous article about GBP due to the fact that last week there was important news coming from the UK which gives insight into the upcoming monetary policy of the Bank of England.

The week in review

On the 14th of July we saw the release of the Consumer Price Index for June which disappointed as it retreated to 0.0% YoY and MoM from 0.1% growth in May. Although the reading was better than in April which saw a drop of -0.1% which was the lowest level in over 50 years, the retreat comes in as a hindrance to the plan of the BoE of embarking on a rate hike schedule. The core CPI, which measures price changes among energy, food, alcohol and tobacco, has slowed to0.8% from 0.9% in May.

These data releases gave a bearish perspective for the GBP. However, afterwards the governor of Bank of England MarkCarney said in his statement that the BoE expects inflation to pick up later this year when the effects of lower oil and food prices subside. Thus, the time for interest rate hikes, which are going to be gradual, is coming closer, however he did not specify when. He said, "the point at which interest rates may begin to rise is moving closer with the performance of the economy, consistent growth above trend, a firming in domestic costs, counter balanced somewhat by disinflation imported from abroad". Therefore, he sees growth of the UK economy being stable and growth not being threatened, with costs stabilizing as any rises are offset by drop in prices of imports. After his remarks the cable has appreciated sharply and moved back up above the 1.55 level.

On the 15th on July we saw that the unemployment rate in May ticked up to 5.6% from 5.5% in the previous month. The number of people employed decreased by 67,000 (to a large degree due to a drop in part time employed) and unemployment claims rose by 7,000 instead of a drop by 8,800 as expected. At the same time wages continued to grow, and even thought at a slower rate than expected, it is the best result since 2010, at 3.2% including bonuses and best result in 6 years at 2.8% excluding bonuses.

On the 16th of July Mark Carney added another statement, that “the time for such increases (rate hikes) will become much clearer by the end of the year”. This clearly implies that no rate hikes for this year are even considered. And only at the end of this year, when we will know whether the inflation rate finally picks up or not, we may receive some further clues on a rate hike time frame.

After these remarks of the governor analysts have changed their forecast for a potential rate hike from August 2016 to May 2016.

The GBP closed the week with a gain of over 3% against the EUR with the EUR/GBP pair going as low as 69.37 for a moment, the lowest level since November 2007.


The GBP also gained against the USD and it was the first weekly gain in four weeks with the GBP/USD closing at 1.56.


The Outlook

The inflation rate dropping to 0.0% once again would imply that an interest rate hike is nowhere to be soon, but the BoE perceives this to be temporary and expects inflation to pick up in the second part of the year. At the same time we see that unemployment rate has risen to 5.6%. These readings support the Phillips curve theory which states that inflation and unemployment are adversly correlated, meaning that when inflation rate decreases uneployment rate increases. This is exactly the case here. However, we must remember that this is the case in short term. And in the long term this does not holds true. Thus, this case supports the Phillips curve theory, but it does not provide us with a long term projection, although in short term we may expect these variables to move accordingly.

Althought there is a small drawback on the labor market, the data on wage growth looks very promising for the UK economy. As wages grew at a rate not seem in many years this raises hopes that inflation will finally pick up. Especially as we heard that the slack in inflation growth in partially due to a drop in imported goods and thus, can be seen as temporary. If the drawback on the labor market is also temporary, then there should no worries about the inflation, as improving employment and rising wages should boost the UK economy and raise inflation.

However, there is one downturn to all this. As adding one more ingredient to the recipe which is low interest rates cooks us a dish called a 'real estate bubble'. This is especially a threat to the growth of the economy when property prices have been rising for some time now and are at very high levels. The BoE has their hands tied as it can not cool down the market with a rate hike as not to hinder growth in other sectors. This is an important argument which could accelerate a decision of a rate hike, but we will see.

Another factor which could add to the housing bubble is the pension fund reform.
Pension reform undertaken by the government of David Cameron envisages new rules which allow future pensioners above 55 years old the right to withdraw their funds from their pension accounts. Due to this only in April and May 250,000 people decided to withdraw their funds to a total amount of over 1.8 billion pounds.
About 75% of this sum has been reinvested in various investment funds which yield a higher return. Some of these investment funds may be investing on the real estate market and with such an influx of capital the prices of properties may be fueled further upwards. People who have decided not to invest the withdrawn capital may have used it for an earlier repayment of their mortgage or consumption. This could add more capital to the real estate market.

Due to the agreement reached between Greece and it’s creditors on the 13th of July the volatility on the bond market last week has decreased substantially. Yields of Eurozone’s peripheral countries as well as the less risky German bonds(10 year) have subsided. The UK 10 year bonds remained almost unchanged and closed last week at 2.08% yield.

Conclusion

The statements of the BoE after the latest data releases give a rather bullish outlook on the GBP. The growth in wages should give a boost to the economy and finally raise inflation. The temporary downturn on the labor market should not be a problem. However, the question remains if it's not too late to avoid a bust on the real estate market.

Another aspect of the BoE statements is whether it was intentional to make a bullish impact on the GBP. First of all, because cheaper imported production components may offset the rising labor costs. This may be an important key factor to the recovery on the UK economy. And secondly, as interest rate hikes in the US are just around the corner, the BoE wants the GBP to gain in value as it predicts months of depreciation.

The GBP/USD after coming down below the upward trend line it has tested it from below. But the question remains whether it will jump back up to continue the upward movement.


In my opinion, in the short term we may see some further appreciation, even to the 1.60 level, so my outlook is BULLISH. However, in medium and long term I stick with my BEARISH forecast as the upcoming rate hikes in the US will weigh down on the GBP/USD. The growth in wages should raise inflation, but we are not sure when. And finally the risk of the UK real estate market overheating is not being addressed.

In the upcoming week, on the 22nd of July, we will anticipate the release of the BoE minutes which will give insight into the stance of other members of the deciding committee on potential interest rate hikes and possible time frame.
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