Sterling Bulls Get It All Wrong

On August 11, the United Kingdom’s Monetary Policy Committee released its outlook on the United Kingdom’s inflationary and economic environment. The report, which offers traders and investors a peek into what the governing monetary policy body is thinking, was not good. It revised the country’s growth and inflationary expectations lower, ending any hope that interest rate cuts were in the cards.

The news was very disappointing for sterling bulls. Over the past few weeks, they had a lot to smile about as things seemed to be moving in the country’s direction. Gross domestic product rose by 1.1% in the second quarter and is now 1.6% higher compared to second quarter results last year. Even employment has improved – job creation is at the highest rate in almost two decades.

The news was good enough to stir speculation that the Bank of England would raise interest rates, or at least tighten monetary policy soon. Traders’ optimism pushed the pound from $1.43 per US dollar to an interim high of $1.60.

But as these traders should have known, one month of positive short-term results cannot overcome the overwhelmingly negative data Great Britain has produced over the last two years. Pound supporters hoped short-term improvement in the economy could advance fast enough to compare with previous quarters. But even a quick look at the data reveals that current growth in the United Kingdom still lags behind healthier activity seen in the last decade. This is true even if you exclude the 2.4% contraction in 2008-2009. And that’s not the only ugly mark against a British recovery.

Manufacturing is a key indicator when it comes to gauging underlying growth. And producers based in the United Kingdom have had to deal with anemic consumption in the euro region and a higher-valued sterling in the last couple of months – making UK products more expensive abroad and uncompetitive. So while the pound’s rising fortunes were good for pound investors, they were bad for UK businesses. As long as the pound stays high, it is extremely difficult for any supported and positive gains for the sector. For the record, sector data has now failed to meet periodic estimates for the third month in four. This means that growth is likely to remain stagnant – making the notions of economic overheating completely ineffective.

Without any real production or economic growth, consumer price inflation can be expected to wane in the short term. Yes, prices are still high – currently rising at about a 3.1% pace. But the figure has been decreasing since April, when prices were rising at an impressive rate of 3.7%.

Moreover, the pace of price gains has been buoyed by recently higher value added taxes, not simple demand. Earlier this year, the UK value added tax – equivalent of a US sales tax – was increased from 15% to 17.5%. Former British Prime Minister Gordon Brown had lowered the VAT in hopes of reviving consumer consumption. It didn’t work. And now the tax is expected to increase next year to 20% under current administration plans.

So instead of naturally rising prices due to supply-and-demand dynamics – more cash following fewer goods – they are rising due to external factors. The lack of demand cannot be more evident than through abysmal consumption witnessed over the last four months. Survey results by the British Retail Consortium have averaged almost -1% on an annualized basis for the April through July period. Without dangers of returning to previous inflationary levels of 3.5% (and already declining levels of inflation), central bankers won’t even begin to consider any type of monetary action, let alone restrictive policies.

So there isn’t any real reason for tighter monetary policy right now. Economic growth is still lukewarm – long-term expectations are for UK growth to average just above 3% spread over 2-2.5 years. The slower growth rate is likely to adversely effect sentiment, production and consumption patterns. UK economic fundamentals remain weak. The Bank of England is not likely to change monetary policy anytime soon. And sterling investors are watching their dreams for a higher pound fall apart.

All those factors are likely to be catalysts for more pound weakness in the coming weeks.

Richard Lee
for The Daily Reckoning