As a rule, currency volatility jumps when uncertainty increases. Not so for Sterling. Brexit has made uncertainty the norm causing traders over the past 18 months to sit on their hands while faced with a binary risk. Binary in the sense that Sterling will weaken in reaction to a hard Brexit or strengthen as a result of a warm relationship with Europe.
Tightening interest rates?
Last week however saw Mark Carney lift the currency markets out of Brexit lethargy by pointing to the need for tighter monetary policy. He couldn’t have been clearer that financial markets are under-pricing the path of future interest rates. He spoke of the potential that should the forecast come to pass “it will require interest rate increases over that period and it will require more, and more frequent interest rate increases, than the market currently expects.”
So does the UK’s economic performance warrant a tightening in interest rates? The economy could at the very least be described as resilient despite the ongoing Brexit unease. Nowhere is this more evident than in the UK employment market, which is historically strong. The unemployment rate is at a 45 year low of 3.9% and wage growth including bonuses hit 3.5% at the last count. This underlying inflationary pressure is of greatest concern to Carney. It is every central banker’s nightmare to find themselves behind the curve and having to chase down inflation. The UK economy has indulged on historically low monetary policy for a prolonged amount of time. Therefore, it is even more important that sharp corrections in monetary policy are avoided.
Sterling nudges towards new highs
While the probability of rate hikes is increasing it remains unlikely that Carney will undertake such an action until the current Brexit impasse is ‘resolved’. However, last week’s signal for the potential of more tightening along with rumours of a softer Brexit have given Sterling support. No wonder therefore we see GBP/EUR nudging two-year highs. History tells us that the current lethargy in the FX markets will not last and currency risks should not be ignored!
As we look across the Atlantic the recent employment report form the US was impressive. The unemployment rate plummeted to a 49-year low at 3.6% in April as an extra 263k jobs were created. This puts the notion to bed that the FOMC could cut rates later in the year.
Upcoming data releases
The economic highlights from the UK for this week will be Q1 GDP and trade data. From Europe we have already seen industrial orders grow by 0.6%, lower than expected.
Otherwise the week ahead is pretty thin on data until the German trade numbers on Friday.
The US will publish trade data, which will be closely watched given Trump’s renewed threat to raise Chinese import tariffs. The week culminates with US inflation data.
For more information, please contact Chris Towner, Director at Chatham, at firstname.lastname@example.org.