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Pound Sterling: Stagflation Concerns Overblown, Recovering against Euro & Dollar

- GBP carrying an 'inflation premium': Nomura
- Stagflation fears overblown: Panmure Gordon
- Recovers some losses against the EUR
- USD remains dominant

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The British Pound was seen recovering losses against the Euro, Dollar and a host of other currencies at the close of the month and third quarter of 2021, supported by better positioning and the publication of some better-than-expected economic growth data.

The Pound was sold heavily at the start of the week amidst fears rising inflation in the UK would scupper economic growth, but any fears of 'stagflation' - where an economy suffers high inflation, poor growth and high unemployment - were calmed after it revealed the UK economy was a lot closer to its pre-Covid size than many economists had thought.

UK Economic growth for the second quarter of 2021 was revised higher by the ONS to 5.5%, against an original estimate for growth of 4.8%.

GDP growth in the year to Q2 read at 23.6%, which is higher than the 22.2% originally calculated.

This means the UK's level of GDP is now 3.3% below where it was pre-pandemic in Q4 2019, revised from the previous estimate of 4.4% below.

UK economic growth

Above: Real GDP in Quarter 2 (Apr to June) 2021 is now 3.3% below its pre-pandemic level (Quarter 4 2019). Source: Office for National Statistics – GDP quarterly national accounts

The data could go some way in convincing markets that a good portion of the economic slack created by the pandemic has been unwound and that the outlook is much brighter than surging energy costs and fuel station queues suggest.

"Given that there is now thought to be less spare capacity in the economy that will only encourage the Bank of England to hike rates in the not too distant future," says Ruth Gregory, Senior UK Economist at Capital Economics.

The data comes amidst a period of intense selling pressure on the Pound which has fallen to multi-month lows against the Euro and Dollar and a number of analysts have turned cautious on the currency as a result.

In a research briefing addressing the Pound's recent losses investment bank Nomura says "the UK inflation premium" is unlikely to fall given the energy crunch in China and the continued rise in supply chain issues.

Gas prices have surged to record levels amidst a tug-of-war between Asia and Europe for any available gas stock while supply chain bottlenecks across a whole spectrum of goods endures.

Nomura finds that the UK is particularly prone to the inflationary effects of energy-driven inflation and markets are signalling UK inflation will outpace that in the Eurozone and U.S.

The Pound is suffering a crisis of confidence over inflation argues Jordan Rochester, a strategist with Nomura, saying "GBP is losing its inflation credibility".

Inflation expectations

Above: Market view of inflation higher in the UK, image courtesy of Nomura.

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"We remain concerned that rising energy prices now will dent confidence, slow growth (even risking outright contraction) and ultimately pull down on inflation at the BoE’s forecast horizon," says Rochester.

The call comes as new data from the Bank of England revealed consumers continued Covid crisis era behaviours of forgoing credit and saving money.

Samuel Tombs, Chief UK Economist at Pantheon Macroeconomics, says consumers "need to lose this cautious mindset quickly if the recovery is to progress, given the looming drop in real disposable income in Q4".

Fading growth puts the Bank of England in a difficult position: on one hand inflation risks rebasing at higher levels the longer the supply-side inflation shock extends, but on the other hand raising rates amidst tepid growth could only add further headwinds to growth.

As such Nomura expects the first interest rate hike at the Bank of England to arrive only in August 2022, which would deal a blow up market expectations for a February interest rate rise.

Any subsequent recalibration by markets would be reflected in falling UK sovereign bond yields and a lower Pound, which appears to have occurred this week:

The Pound-to-Euro exchange rate fell from a weekly open at 1.1664 to reach a low at 1.1548 on Wednesday before recovering to 1.1640 at the time of this article's update.

The Pound-to-Dollar exchange rate went from an open at 1.3665 to a low at 1.3411 and is back at 1.3492 at the time of writing.

Pound to Euro and Dollar sept 30

Above: Four hour chart of GBP/EUR (top) and GBP/USD (bottom).

Rising volatility in the currency leaves Rochester to say that from a strategic perspective "the current uncertainty in GBP is not worth holding any longs for".

Headlines of surging energy prices and the prospect of goods shortages ahead of Christmas will likely prompt caution amongst consumers who remain the engine of UK economic growth, meaning the UK economy will only likely recapture GDP lost to the crisis by 2022.

Slowing growth and high inflation have ignited speculation that the UK is headed for a period of stagflation, whereby an economy is beholden to a toxic combination of high inflation, a growth slowdown and high unemployment.

But Simon French, Chief Economist at Panmure Gordon, says this is not the case.

While financial headlines are increasingly populated by the term 'stagflation' when addressing the UK economic outlook, "I think this is an unlikely outcome," says French.

French says the ending of the Government's furlough scheme at the end of September will not spike the unemployment rate to truly stagflationary levels.

Although there will be frictions as regional, skillset and housing tenures get in way of matching up the one million vacancies with the unemployed, French says the age of furloughed workers is reason to be optimistic that the rise in unemployment will be brief.

"Strong household balance resilience - not just almost £200BN of additional savings but also benign credit conditions - should provide momentum for consumer spending," says French.

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He also says the Government's budget won't necessarily be the contractionary event many economists say it is, rather it is best described as "a redistribution of spending rather than a macro headwind".

French concedes that inflation has been higher and will be longer-lasting than he initially expected.

But he maintains there are structural arguments for lower negotiating/pricing power for the majority of workers, suggesting inflation won't become entrenched.

Pound Sterling Live reflected on Wednesday that the Pound's sell-off was starting to look excessive.

Investor sentiment is febrile and that the UK is materially worse off than anywhere else would need to be blindingly obvious for this to become a longer-term trend.

As mentioned, the rest of the world are facing energy crunches and supply chain disruptions, the UK is not alone.

"The pound’s weak patch is not expected to last beyond the near term," says Asmara Jamaleh, Economist at Intesa Sanpaolo in a Wednesday briefing to clients.

Jeremy Stretch, Head of G10 FX Strategy at CIBC Capital Markets says that for the Bank of England the labour market will provide the true litmus test of whether interest rates can rise.

If the ending of furlough is relatively benign then the Bank might find itself more confident in raising interest rates.

"Absent a labour market breakdown, we expect the bank to look to hike again in H2 2022," says Stretch.

Strong labour market readings in November and December could therefore offer a strong incentive for investors to take another look at the Pound.

"BoE activism in the face of above trend growth and inflation contrasts with the central bank laggards. That suggests Sterling will perform well against the EUR, JPY and CHF," says Stretch.

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