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Last week’s Conservative manifesto showed Theresa May targeting the centre ground. She has calculated, almost certainly correctly (although she will be alarmed by the recent narrowing of the polls) that the Opposition is in such a mess that she can risk alienating elderly core Tory voters by increasing social care costs and ending the controversial pensions ‘triple lock’ adopted by the 2010-2015 Coalition. The triple lock has now become a ‘double lock’ and a Tory victory will mean that state pensions will rise only according to the higher of CPI and average earnings. The 2.5% part of the triple lock which effectively floored pension increases at that level, however low inflation and earnings fell, has been abandoned.
Last Tuesday, we learned why the Conservatives have been able to justify this change. CPI in April rose to 2.7% year on year - up from March’s figure of 2.3%, so the old 2.5% floor on pensions is redundant for the foreseeable future. RPI, still arguably a better reflection of the rise in the cost of living, rose from 3.1% to 3.5%. Meanwhile, RPIX (excluding mortgage costs) rose from 3.4 to 3.8%. The Bank of England continues to argue that the re-emergence of inflation is all down to sterling’s depreciation since the referendum.
However, this seems unlikely. Inflation is even picking up in the eurozone – which for years flirted with outright deflation – where CPI is running at 1.9%. It is true that EUR/USD fell by around 25% between May 2014 and March 2015, but the effects of that slide would have worked through by now. The rate has been range-bound since, with no further severe sell-offs like the one experienced by sterling in the last year. Yet even in Europe, the deflationary forces are on the wane and inflation is picking up without the benefit of currency depreciation.
It is likely that, just as in the eurozone, UK inflation has much to do with the eventual, inevitable result of ultra-loose monetary policy. Clearly, sterling’s fall has had an effect but it is not the whole story. Mark Carney will ‘look through’, i.e. ignore, this resurgent inflation. The problem is that as he does so, and CPI increases, real interest rates will fall ever further into negative territory. This implies ever looser monetary policy which is beginning to create inflationary forces that go far beyond those caused by a 10% fall in the pound.
There is much talk at the moment to the effect that ‘this time it’s different’ as if the Great Financial Crisis somehow changed the effects of monetary policy on the economy such that rates will now be able to stay much lower for longer. In truth, they already have done and the inflationary effects have been observable for years in asset prices, even if the inflation indices themselves are only belatedly reacting.
If last week was anything to go by, Carney’s ability to blame the weaker pound for Britain’s inflationary ills may already be approaching the end of its lease. It has long been argued (including here) that, as inflation caused falls in real earnings, consumers would be forced to rein in discretionary spending as an ever greater proportion of income went on utilities and other essentials. This all seemed to make sense, given March’s weak retail sales figures. Then, last Thursday, April’s numbers were announced showing retail sales ex autos rising a robust 4.5% year on year against expectations of only 2.6%. This was enough to propel GBP/USD briskly upwards through the psychologically significant 1.3000 level, where it remained until selling off slightly this morning to trade at 1.2997 at the time of writing. Sterling also received support from Friday’s CBI industrial trends survey for April, which saw manufacturing orders at a two-year high. Interestingly, against this surge in GBP/USD, the FTSE 100 held up rather well. The stock market seems to have broken its inverse trading link with GBP/USD.
Tourism, on the other hand, has most definitely not broken its inverse correlation with the GBP/USD rate, with Expedia reporting an 80% increase in bookings to the UK by Americans between January and March compared with the same period last year, when the exchange rate was some 9% higher – despite sterling’s recent recovery. Perhaps we really are set to witness some long-awaited rebalancing of the economy.
While sterling’s upward move against the dollar has been impressive, against the euro it is a different story. Against a backdrop of general dollar weakness caused by the evaporation of belief in the ‘Trump trade’, as it becomes clear that the President will struggle to get much done at all(or even survive), the euro has powered ahead to 1.1223 against the dollar. Meanwhile, GBP/EUR has been pushed down to 1.1579.
The euro is often used as a funding currency for ‘carry trades’, where traders borrow euros and sell them to buy other higher-yielding currencies or assets. This means that traders tend to be short euro when they are in a ‘risk-on’ frame of mind. Last week’s shenanigans over the sacking of FBI Director, James Comey, and the suggestion that his dismissal was to cover up Trump’s links with Russia, will have persuaded many to go ‘risk-off’, unwind carry trades and buy back short euro positions. The combination of an ongoing market reassessment of Trump’s presidency and short covering saw EUR/USD move sharply higher by some 2.5% last week.
This week will pander to the British national obsession, with house price data from Rightmove tomorrow, followed, on Thursday, by BBA mortgage approvals which are expected to have fallen slightly to 40,800. Thursday also sees the provisional estimate of UK Q1 GDP which is expected to confirm the flash estimate of 0.3% compared with Q4 2016. We have US and eurozone PMI data tomorrow. US manufacturing and services are expected to return 53.1 and 53.3 in May, compared with the eurozone’s more robust 56.5 and 56.4. Any out-performance by the eurozone is likely to push EUR/USD higher still.
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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