The UK amongst the World

Discussion and Analysis by Charles Porter:

This week will challenge the strength of the Great British Pound and thereby generate considerable upside and downside risks. However, the materialisation of UK performance may be subsumed within broader, global, currency trends.

Saying a prayer this weekend was perhaps the most useful form of global speculation. Following North Korea’s nuclear test on Sunday 3^rd September, Seoul, the capital of South Korea, frightened global markets with admonitions of further missile preparation. Whilst tension was building in the Peninsula, a tropical depression was maturing within the Atlantic Ocean, generating damage expectations in the order of hundreds of billions of US Dollars. Therefore, a risk-off strategy spurred the value of traditional safe-haven assets whilst eroding the worth of dominant currencies. With two climactic exogenous events, one geopolitical and the other natural, there was very little consensus on how markets would open this morning.

In contrast, this week, especially with respect to the pound sterling may be more transparent and discernible. For example, today will see a salient vote within the House of Commons take place. This vote is on the second reading of the European Union (Withdrawal) Bill; the Repeal Bill. The Pound will be sensitive to the success and fluidity with which the Bill passes through Parliament due to its importance. By repealing the 1972 European Communities Act, the act through which the United Kingdom acceded to the EU, its Repeal will forecast the path forward for the UK, post secession.

Any evidence of considerable headwind, from Conservative/DUP rebellions, filibustering attempts, or abstentions, will introduce a degree of uncertainty within the UK market and the currency. In the absence of headwinds or market-sensitive reforms to the Bill, the GB Pound should encounter an appreciative tailwind while the currency yearns for any solid, tangible confidence in the Brexit process.

The Monetary Policy Committee of the Bank of England will also announce their latest decision and interest rate target on Thursday. The previous Decision saw a 6-to-2 division within the Committee in favour of keeping the base rate fixed at 0.25%. However, markets had anticipated a more divisive vote with a greater impetus in favour of a rate hike in line with the votes of Michael Saunders and Ian McCafferty. In fact, the 3-1 ratio saw a considerable depreciation of the Pound as markets had priced in a more optimistic recovery and macroeconomic impression than the Bank. A graph depicting the devaluation is presented at the end of this article.

With numerous central bankers over the past few weeks, from Europe to Canada, attesting to the resilience and bite of the global economic recovery, we wait to see whether the Bank shares this perception despite Brexit uncertainty. Whilst the vote of Michael Saunders in particular seems certain and in favour of a hike, forecasting other members’ decisions is less straightforward.

The clarity of the rate decision will improve during the run up to Thursday. Given that the Bank’s mandate, delivered by the Chancellor of the Exchequer, revolves around a 2% inflation target, tomorrow’s Consumer Price Index inflation indicator will frame and even forebode the Decision. Moreover, Wednesday will see statistics released relating to the health and performance of the UK labour market. Whilst a rate hike should not be expected, a more Hawkish tone regarding monetary policy and vocal condemnation of Pound’s weakness could see a credible, confidence and expectation-based appreciation of the Pound sterling.

A considerable amount of the upside risk will already be priced into the currency and assets denominated therein. Therefore, a failure to meet these expectations will result in the converse effect; a depreciation of the currency as accelerating, above-mandate, inflation is not curtailed. This week’s events therefore deliver a considerable propensity for a re-evaluation of the UK political economy. Despite this importance, global geopolitical uncertainty, in our opinion, still contains the propensity to divert attention away from developed markets, threatening to insulate global currencies from idiosyncratic national events.

August 3^rd 2017: Previous Bank of England Monetary Policy Decision. The Graph above shows an intraday currency fluctuation in excess of 1 percent. The devaluation of the GBP vis-à-vis the Euro is the market response to a Dovish and relatively undivided Monetary Policy Decision. The devaluation is therefore precipitated by the downward revision of future monetary policy expectations and an internalisation of the Bank’s apparent low confidence in the global economy and the possibility for future interest rate normalisation.