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After the sharp rise in UK medium and longer term rates seen over the past month, the market staged a mini-rally last week as GBP displayed a bit of poise, particularly against EUR, following its dramatic post-referendum decline. Unfortunately, last week’s calm conditions are unlikely to prove the norm over the next few months in the lead up to the start of Brexit negotiations.
There are very few domestic economic indicators being released this week, but Thursday sees the release of the preliminary estimate of third-quarter GDP. This is regarded as a pretty crucial number as it is the first that will give a full reading of the performance of the UK economy since the referendum. Initially, it was thought that the UK would do well in the immediate post-referendum period if it avoided a negative result. This expectation was fully supported by the awful CIPS PMIs that were announced in August for the manufacturing, construction and service sectors.
Since then, and since the further slug of monetary easing announced by the MPC, we have seen a major recovery in the manufacturing and service sectors back to levels that would be regarded as supporting a perfectly healthy economy. The construction industry has not enjoyed such a strong rebound but, fortunately, that has a smaller impact on the calculation of GDP. Quite apart from CIPS surveys, we had further evidence from retail sales figures showing that consumer spending is much stronger than earlier in the year, and that Brexit does not yet appear to have had any negative impact on employment levels.
The net result is that the median forecast of the flash estimate is a rise of 0.3%. This is hardly comparable to the surprisingly strong 0.6% for the second quarter, but that was almost totally ignored on the basis that it would be slammed post-referendum. Economists are now having to rework their forecasts for the full year, with most going for an increase of about 2%. If the 0.3% forecast for the third quarter proves to be correct, a rise by a similar amount in the fourth would bring about the 2% level. While 2% for the whole year is hardly an exciting figure, it could not be described as showing the UK economy to be at death’s door.
If third-quarter GDP manages to record a 0.3% rise or better, it will put the Bank of England’s MPC in an interesting position when it meets on 3 November. This is in large part due to the latest inflation figures, which saw the CPI inflation measure rocketing up to 1% with the expectation that it will motor straight through the 2% target level in the coming months.
The MPC made it clear three months ago, when it reduced its base rate from 0.50% to 0.25%, that it was likely that this would need to be followed by a further cut before the end of the year. This was taken by most to signify that November’s meeting would result in base rates falling to 0.10%. The much better than expected economic performance over the past three months has led the market to believe that Mark Carney’s forward guidance is, once again, going to prove inaccurate. Economists are not so sure and are probably evenly split on whether a final cut will be forthcoming next month.
The market is decidedly more jumpy than most economists over how the MPC will react to the surprisingly strong performance by both the inflation figures and the overall economy. Even the Bank of England’s forecasts show the CPI number comfortably breaching the 2% target level and the median topping out forecast is probably around 3%, although some forecasters have penciled a high of as much as 4%.
Third-quarter GDP figures are likely to prove crucial in determining the MPC’s decisions on monetary policy at their November meeting. There is no doubt that they wish to keep rates low, and Carney has already made it clear that he would be prepared to look through a short period of high inflation. However, if the market perceives that the MPC are playing fast and loose with inflation it will achieve the opposite result, with medium and longer term rates rising as overseas holders continue to sell out of their gilt holdings. They are also in the unenviable position of having a new Prime Minister who feels free to comment on monetary policy by pointing out, completely correctly, that QE has the unwelcome effect of merely pushing the value of non-productive financial assets higher (or, in her language, how the rich get richer).
Almost all major central banks are currently under pressure given that their strategies are showing limited signs of success and, increasingly, are going to have to prove why those strategies will eventually prove effective. The MPC is no exception, and how they will react may have a major impact on both the currency and the interest rate yield curve – of which more next week.
All views expressed here are the author’s own and are based on information and data available at the time of writing.
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