Pound Pares Gains Vs Euro and Dollar But Renewed Economic Momentum Seals Deal For Interest Rate Hike

Market pricing now implies a 90% probability the BoE will hike rates in November. Expectations of what happens after this time are now the most important thing for Sterling.

The Pound-to-Euro rate gave up some of the previous session’s gains during early trading in London Thursday but the outlook remains robust in the wake of a third-quarter GDP report that sealed the deal on expectations the BoE will hike rates next week.

Since Wednesday’s growth number, bond markets have assigned an 89% probability to the idea the Bank of England will raise the base rate for the first time in a decade.

Third quarter GDP rose by 0.4%, according to Office for National Statistics data released Wednesday, faster than the 0.3% rate of growth expected in by economists.

Strength in the services sector was the greatest contributor to growth, with computer programming, motor trades and retail trades all performing strongly, although the construction industry slipped into recession with a back-to-back contraction over two quarters.

“Industrial production appears to be reflecting the strength of the surveys at long last, posting a strong 1.0% quarterly rise," says Paul Hollingsworth, a senior economist at Capital Economics. "Meanwhile, despite the ongoing real pay squeeze, quarterly growth in the services sector managed to hold steady at 0.4%. The Q3 figures leave the economy on track to grow by about 1.6% this year."

The Pound-to-Euro exchange rate rose more than 100 points over the course of the Wednesday session, to reach a high of 1.1260, but dipped back down to 1.1185 overnight and during early trading Thursday.

The Pound-to-Dollar added more than 160 points, to reach a peak of 1.3264, but has since fallen back to 1.3195.

It wasn’t just the Euro that wilted in the face of the market’s reappraisal of Sterling Wednesday, only to pare losses later, as the Pound also saw a volatile performance against the Canadian and Australian Dollars as well as the South African Rand.

GBP/ZAR Price action came as traders turned bullish Sterling and bearish Rand simultaneously in the wake of the UK's GDP report and the South African government’s latest budget plan, which unveiled an expected 1% increase in the budget deficit.

"[Wednesday's] GDP figures revealed that the economy re-gained a bit of momentum in the third quarter and have probably sealed the deal on an interest rate hike next week," adds Capital Economics' Hollingsworth. 

Not only did Wednesday’s GDP report show that policymakers and the market may have underestimated the resilience of the economy, it also highlighted an eagerl anticipated, but long-absent, boost to the export sector. 

"Export-related sectors currently benefit from the healthy expansions in the UK’s major trading partners, the US and the Eurozone, and a tailwind from the weaker sterling – which is down 12% on a trade-weighted basis since the Brexit vote on 23 June 2016," says Kallum Pickering, a senior UK economist at Berenberg

Pickering's call is noteworthy as he began forecasting a rate hike from the Bank of England at the end of August, when some in the market were questioning whether the BoE might need to cut rates further to support the economy. Pound Sterling Live reported on this contrarian call at the time

Importantly for Sterling, Wednesday’s data could now see traders begin to reappraise the currently-low probability of additional rate hikes to come after November, which could drive a renewed upturn in Sterling.

"While the market now expects the first hike in November, having recently brought forward its expectations from as late as 2019, current pricing suggests the market is anticipating only one further hike in 2018," says Pickering.

The Bank of England said in September that it could begin withdrawing stimulus from the economy in the “coming months” if the economy continues to follow a path consistent with the gradual erosion of spare capacity. It also said the relatively moribund economic conditions of the second-quarter represented such a path.

"We therefore expect the BoE to strengthen its guidance after the first hike, leading to a somewhat steeper gilt curve and possibly a stronger sterling on a trade-weighted basis by the turn of the year," Pickering adds.

Berenberg currently forecast that the Bank of England will raise the bank rate by 25 basis points to 0.50% next week, on November 02, and follow this with another four 25 basis point increases between now and the end of 2019.

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Consumer Lending Edges Higher, Rate Hike Doubts Binned 

Wednesday’s rally in Sterling follows a sell-off late on Tuesday that may have been brought on by renewed efforts from Bank of England rate setter Jon Cunliffe to talk down the case for a hike next week.

A possible deepening slowdown in the economy was among the main reasons why Cunliffe sought to play down the need for a rate hike, but with the economy regaining momentum these fears would now appear to have been consigned to the bin. 

"Even though real GDP growth has slowed a little this year compared to 2016, because of Brexit, firms are not supplying goods and services quickly enough to meet the growing demand. As a result, underlying inflation is rising," says Pickering. 

"Without modestly tighter monetary policy to keep inflation expectations firmly anchored at the 2% target, underlying inflation would continue to rise and the BoE would have to raise rates by more at a later date which would risk choking off the expansion."

Pickering is not the only one to have written in recent days about how such concerns might have been overly pessimistic from the get-go. Ben Powell CFA, a multi-asset class content salesperson at Swiss bank UBS, wrote Tuesday about how the UK economy remains on a much firmer footing than many of the current activity indicators appear to suggest. 

Powell's synopsis was that UK households have never had it so good, with total household wealth having set new records repeatedly over the last 18 months, and that the BoE needs to act in order to avoid a growing bubble in consumer credit posing a threat to financial stability. 

His comments on consumer credit were borne out by UK Finance data released Wednesday morning, which showed consumer lending edging higher during September, growing at an annualised rate of 5.5%, while mortgage lending continued apace with the value of total loans expanding by around 5%.

“As we near the end of 2017, our data is showing that housing market activity has built up modest momentum since the start of the year, helped by an increase in first-time buyer numbers,” says Mohammad Jamei, a senior economist with UK Finance.

Policymakers have recently expressed concerns over “frothy” conditions in the market for consumer credit. The problem for the Bank of England is that households are continuing to take on unsecured debt, even as rising inflation erodes real incomes and the capacity of borrowers to service loans.

“Rising inflation continues to put pressure on household budgets which is impacting consumer spending. Consumer credit growth has edged up a little compared to last month, but is in line with annual growth rates over the last year,” says Mohammad Jamei, a senior economist with UK Finance.

Pound Sterling Live reported on Tuesday about how consumer credit fears could take precedence for Bank of England policymakers next week, even if the third-quarter GDP report hadn’t been as solid as it was.

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