Optimism from the Governor

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Optimism from the Governor

The pound spiked up against the US Dollar on Thursday morning as the Bank of England governor Mark Carney expressed optimism following improved, updated economic data for the second quarter of 2018. In his remarks he made it clear that the subdued economic performance in the first part of the year was “largely due to the weather, not the economic climate”.

GBP vs USD Spot Price

Source: Bloomberg, data as of 5 July 2018

Prior to Carney’s speech in Newcastle, currency markets had already started to boost sterling v the dollar (also known as the ‘cable’ rate). Sterling remains low by historical standards and likely to remain volatile in the face of uncertainty over Brexit.

However, the positive tone from the Bank of England did raise analysts’ expectations of an August 2018 interest rate rise. The probability of a quarter point being added to base rates increased from 66% to 82% and we are getting close to this being a near certainty next month.

Beyond August, gradual rate hikes are expected to continue in line with the strength of the economy. The expected pattern of gentle hikes is demonstrated in the below chart.

Consensus of Analyst Forecasts for UK Central Bank Interest Rates

Source: Bloomberg, data as of 5 July 2018

While currency investors responded quickly to governor Carney’s signal, bond investors were more sanguine, noting the lack of timelines and definitive guidance. Lack of real clarity reflects several factors weighing heavy on the mind of Monetary Policy Committee’s (MPC). For example, the inflation target must be considered but at the same time the MPC must also support government objectives for growth and maintaining high employment levels.

Nevertheless, some of the uncertainties holding back economic performance in the earlier part of the year appear to have lifted. For example, the MPC acknowledge that the labour market is going from strength to strength. Unemployment levels are at their lowest levels since 1975 (4.2%) and business demand for labour keeps increasing. The corresponding rise in wages is helping consumer demand now that real disposable incomes, after inflation, are rising.

Since the onset of the financial crisis a decade ago the shift toward ultra-low interest rates has been very beneficial to the UK. It has helped businesses to improve their profitability and, in many cases, lengthen the duration of debt on balance sheets lowering the cost of financing their debt.

However, the BoE recognises that one of the risks of keeping interest rates at unprecedentedly low levels is an inability to cut them meaningfully again if economic growth falters in the future. In the last meeting of the MPC, three members voted in favour of an increase with the remaining six in favour of maintaining the current level at 0.50%. None of the members voted to lower rates, a sign that members are beginning to sense that the economy is capable of sustaining itself.

Carney’s slow and steady approach is an effort to shelter economic progress achieved to date. He wants to continue to support growth whilst controlling inflation at target levels of 2%. Getting interest rates higher is not necessarily negative. Watching the US economy from this side of the pond we note how the Federal Reserve has managed to push rates higher without derailing growth. As soon as the US economy appeared healthy enough, their central bankers started to show greater determination and willingness to push interest rates higher. This approach comes straight out of the central bank interest rate setting playbook.

With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. Past performance is not a guide to future performance. Tax rules can change at any time. This blog is not personal financial advice.

Global Markets