After a 1-year rally against most of the currencies, the British pound has switched from the ‘market’s darling’ status currency to vulnerability since the middle of July this year. There are many reasons that could explain this reversal: a shift back in expectation of the BoE ST monetary policy (Rate hike now priced in for Q2 2015, instead of Q1 last summer), the Scottish referendum effect in early September, the Fed ‘waking up’ and a slowing momentum concerning UK macro indicators.
Personally, I have always been faithful to the pound, and I have most of the time looked for buying opportunities against other currencies (especially crosses like EUR, JPY or AUD).
However, today I would like to focus on a longer term effect that could weigh on the currency, which is the government budget and UK’s ballooning debt. It is what I call the ‘nightmare topic’ that nobody wants to talk about as when you look at the figures (for UK and most of the countries, if not all), you understand that the effects of the GFC are not over yet and that countries will be exposed to higher taxes (corporate, revenues) and spending reduction, slowing down the consumption.
After a GBP 107.7bn recorded in the fiscal year to end-March 2014 (FY 2013/14), down from GBP 115.1bn a year earlier, UK borrowing as a percentage of GDP fell to 6.6% according to the ONS, which corresponds to its lowest level since GFC. I put added a great pie chart in Appendix (Source: the Guardian) so that you can visualise the countries total receipts and expenditures.
If we have a look at the chart below that shows the country’s net borrowing (as a percentage of GDP) over the past few years, we can conclude that we are far from the 11.0% (according to EuroStat) recorded in FY 2009/2010. Therefore, we can say that we have seen some improvement based on those figures.
However, the high levels of today’s UK deficit (still two times higher than the 2003 – 2007 era) make it difficult for the country’s public debt to stabilize. Based on the ONS data, UK public sector net debt was recorded at GBP 1,4bn in August 2014, which is equivalent to 77.4% of the country’s GDP.
With the unemployment rate down 2.5% to 6% in the last three years and now standing at [Sept] 2008 levels, expenses for unemployment benefits (one of UK main expenditures) have definitely decreased and the Queen should receive higher tax revenues.
However, if we have at the last government spending figures, most of the monthly borrowings came in higher than expected since the beginning of the FY 2014 / 2015. For instance, Government spending in September was GBP 11.8bn, which was GBP 1.6bn higher than September 2013 (and £1bn above consensus).
In the first 6 months [April – September] of the fiscal year, borrowing was £58bn, which is £5.4bn higher than last year’s figures. I read that economists are already stating that Osborne’s 12-billion target reduction (on borrowings) sounds quite optimistic based on those figures.
Moreover, if the trend continues, some of them are saying that borrowing can come £10bn above expectations, which could be quite dramatic for the Chancellor of the Exchequer (some analysts call it the ‘Government’s Achilles’ Heel’).
Therefore, we can conclude that full employment (which I believe is now almost reached) is not the only factor to consider bringing the debt back to sustainable levels. Moreover, it is not surprising that Carney switched to a ‘qualitative guidance’, taking into account a wider range of economic data (as the Fed did).
One of the main factors that will weigh on UK’s yearly receipt is of course the weaker-than-expected wage growth. If we have a look at the chart below, we can see that despite a decreasing inflation (orange line, +1.2% YoY in September, which is now also problematic for the Bank of England), average weekly earnings (3M average) are also trending lower to critical levels (black line, 0.7% YoY in August), far from pre-GFC levels (4% on average between 2001 and 2007).
And like all the developed economies, falling real wages won’t stimulate the consumption-driven economy (70% as a share of GDP). Remember that since the BoE cut its average salaries forecast by half to 1.25% for 2014 in its August Inflation Report, investors have been speculating on a later-than-anticipated rate hike (Q2 2015, instead of Q1), driving preference for the US Dollar.
To conclude, even though the UK economy is now worth more than its 2008 peak (since this summer to be precise) and is expecting to grow by 3.1%-3.2% this year (one of the highest growth rate among developed economies), the tightening cycle isn’t priced in yet by investors and looks difficult to interpret.
In my opinion, if the situation remains steady in the coming months (low unemployment, but falling real wages and poor consumption), next year’s rate hike will just be symbolic (1-percent shift maximum). Unless things change drastically (which I doubt), the so-called neutrality (ST rates back to pre-GFC levels) may be a longer-than-expected process.
Quick chart on Cable:
As I mentioned earlier, the British pound has gone through a difficult period for the past few months; as you can see it on the chart below, Cable is down more than 10 figures since its mid-July high and has been oscillating around the 50-percent Fibo retracement (1.6000) of the 1.4812 – 1.7191 interval since the beginning of October.
My view goes for a higher Cable ahead of the FOMC meeting this week, with a first ST target of 1.6200. Higher levels (1.6300) would imply a dovish statement from the Fed, surprising the market by either extending the QE purchases or expressing some concerns about the inflation/global outlook which will directly impact trader’s view on the ST monetary policy.
I don’t think both of these options will happen on Wednesday. I will go for a neutral tone, slightly dovish, but not enough to disappoint the market; and in case this scenario happens, above 1.6200 could be considered as a good level to short Cable again.
On the downside, the 1.5850 support looks strong for the moment. For the trade idea, it could be worth trying to sell Cable between 1.6200 – 1.6230 for a test back towards 1.6050 and a stop loss above 1.6310. I know that the idea sounds a bit risky, but I think Yellen did her job at the last minutes and I don’t see anything new that could surprise the market.
On the crosses, I am still short EURGBP (entry level 0.8000), and I am looking for the 0.7750 retracement. My MT target remains at 0.7500, as I still think the Euro will extend its loses against GBP and USD in the medium, and each time its ST consolidation is kind of capped against those two currencies.
Appendix:
