Forex Investment and Currency Trading

The UK economy continues to display surprising resilience to the US slowdown and the global credit crunch giving the Bank of England (BoE) greater leeway to separate its monetary policy response to moderating growth from its actions to provide liquidity to stressed financial markets.

Retail sales surged 1.0% mom in February despite expectations for a modest fall of 0.2% mom. Moreover, the January advance of 0.8% mom was revised up to an even more buoyant 1.1%. Despite a number of apparent headwinds bearing down on UK households, consumer spending continues to hold up in early 2008. The January/February average of sales was up a whopping 1.5% above the 4Q average.

There was strength across the board apart from household goods which plunged 4.2% mom, the largest monthly decline in 7 years, likely reflecting slowing activity in the housing market. Elsewhere  the gains were robust. Food sales surged 1.6% mom, non-specialised department store sales gained a healthy 2.7% mom while even clothing & footwear was up a buoyant 2.5%. After jumping 3.4% mom in January, non-store sales (internet and mail order) still increased a further
1.6% mom in February.

While the surge in retail spending last month appeared to point away from the need for the BoE to cut rates next month already, as the markets had been predicting, the minutes to the BoE’s monetary policy meeting earlier this month revealed that two members of the committee voted for an immediate 25bp rate cut. The market had expected only arch-dove David Blanchflower to vote for rate easing. In the event, Deputy Governor Sir John Gieve, who is in charge of financial stability,  also wanted to lower rates.

The doves key concern was that, in the context of a deteriorating US economy and renewed stress in financial markets, the 50bps of easing since late 2007 had been offset by increases in market rates, likely leaving monetary policy still slightly restrictive. Sterling 3-month libor, for example has risen 30bps over the course of this year. Importantly, the doves noted that a rate cut in the Spring was already expected by the markets—a view broadly backed up by the February Inflation Report (IR). As a result of downside risks to the economy, the doves saw no need for a delay in
easing the monetary stance.

Most MPC members felt, however, that the balance of risks between inflation and the economy had not changed much to merit a rate cut in March. In particular, they argued that a consecutive monthly rate cut would lead markets into thinking that the BoE was too focused on downside risks to demand relative to the upside risks to inflation. These members worried such a view could lead to an “exaggerated response” in market yields as market participants looked for a more dramatic easing in the Bank Rate than the February IR had signaled.

The minutes continue to imply that most MPC members are not champing at the bit to lower rates. The minutes acknowledged that survey data in early 2008 had been mixed, suggesting less of a slowdown in the economy than had been expected at the time of the February IR. Last week, the CBI industrial trends survey backed up improvements in both the CIPS services and manufacturing PMIs in February. The CBI’s closely watched order book balance jumped to a 5 month high of +7 in March from +3 in February. While the MPC saw “mounting evidence” of a weakening US economy, it also noted that the Eurozone and Asia “did not seem to be seriously affected” by the global credit crunch so far.

Concerns about inflation remained at the fore. The minutes re-emphasised that the BoE expected a sharp run up in CPI inflation in coming months due to surging food and energy prices. The acceleration in CPI inflation to 2.5% yoy in February from 2.2% the month before would have partially validated BoE forecasts which project a 3% peak during 2Q 2008. The minutes also worried that the fall in the sterling effective exchange rate which had been greater than envisaged in the February IR—plunging 7% against the 2H 2007 average—would probably compound the surges in food and energy prices.

However, it has not been all bad news. Despite factory gate price inflation at 16 year highs, Bank Agents reported that businesses facing consumers “felt unable” to pass all of their costs increases into higher prices. Moreover, the February minutes noted that data on wages so far implied little pass-through of rising inflation and elevated inflation expectations (3.3% in February). Indeed, data released last week showed that growth in headline average earnings slipped to a restrained 3.7% 3m yoy from 3.8%. Ex-bonus earnings, meanwhile, remained unchanged at 3.7%, well below the 4.5% level that the BoE sees as compatible with achieving the 2% CPI inflation target. Still, the February BoE minutes acknowledged that the key risk was that households may provide growing resistance to falling purchasing power by demanding higher wages.

Blanchflower and Gieve had effectively signaled the December 25bp rate cut to 5.5% last year by being the only members to vote for a rate ease in November. Could history repeat itself again in April? The pattern of rate easing so far—only two 25bp cuts this cycle—has been every other month. While we do not discern a major drive to get rates lower fast, the BoE has clearly signaled an easing bias despite concerns over inflation. Notably, the BoE continues to expect the hump in
inflation to be temporary, dragged down by below trend growth. These projections have likely been bolstered by the fall in core CPI inflation to a very benign looking 1.2% yoy in February.

Market believes that consumer spending will slow as the year progresses and as economic growth moderates, the housing market continues to correct and, crucially, unemployment begins to rise. However, with survey data pointing to a degree of resilience in early 2008, the much better than expected retail sales data point away from a rate cut in April. For the BoE, not only is the economy holding up, but inflation concerns continue to grow. While there remains a significant 40% risk that the BoE could move next month already, market continues to believe that the BoE will hold off until May before lowering the Bank rate 25bp to 5.0%.