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6 November 2013
Not Over Until the Old Lady Sings
The recent run of strong UK data and accelerating house price inflation will be
brought into sharp focus this week by the Bank of England rate decision,
followed by the publication of the November Inflation Report next Wednesday.
We don’t think either is likely to catalyze renewed sterling strength.
Firstly, the chances of the BoE delivering a surprise are not high. Barring a
shock on Thursday, market attention will be focused on the Inflation Report.
There, probability forecasts for the unemployment threshold and inflation
knockout will be most scrutinized. On the former, the current estimate of a
50% probability of unemployment reaching the threshold by end-2016 looks
unrealistic relative to growth and productivity trends.* But the market is
ignoring this forecast anyway, with the first hike now priced for Q2 2015
versus Q3 2015 in August. On inflation, we do not think that ascribing a
greater than 50% probability to CPI being at or above 2.5% in 18-24 months
time is likely given the MPC’s penchant for forecasting above-target inflation
back to target. This leaves qualitative guidance. Noises on inflation
expectations (see above) and housing (we have already argued ex. London
price rises have been modest) should be muted. The most likely source of a
‘hawkish’ surprise became would be if the Bank more cautious on productivity
growth, but having established a narrative of productivity improving with the
economy, any backtracking is likely to be incremental.
Secondly, while PMIs have remained at nose bleed highs, correlations between
sterling and output have collapsed (see chart 1). The relationship back to the
early 1990s has never been stable, even for construction which tends to drive
the policy cycle, and this is probably a product of the UK’s tendency to run up
fearful external balances in times of economic expansion.
Thirdly, rate differentials are not supportive. EUR/GBP is bang in line with 2Y
rates, while 2Y2Y swap rates are very slightly higher for GBP, which seems
fair. GBP/USD looks expensive compared to UK-US rates across the curve.
No relationship between sterling and growth
GBP bang in line with rates
2y correlation GBP TWI with services output, smoothed
UK-Eurozone 2 year rates
EUR/GBP (inverted, rhs)
Source: Deutsche Bank, Bloomberg Finance LP, Macrobond
Source: Deutsche Bank, Bloomberg Finance LP
The BoE illustrative examples showed unemployment reaching 7% by mid-2016 with 2.5% four quarter growth and
1.5% productivity growth. Survey implied annualized Q4 growth is 5.2%, 4 quarter average productivity growth -1%
Deutsche Bank Securities Inc.