Forex Investment and Currency Trading

While UK economic growth has remained resilient compared to the US, the British economy continues to show signs of the potential for a sharp deterioration in the months ahead. However, surging inflationary pressures will likely prevent the Bank of England from cutting interest rates again ahead of 4Q 2008. Since the MPC’s May 8th meeting, when the BoE somewhat unexpectedly kept rates on hold at 5.00%, the market has dramatically altered its expectations of UK interest rates in favor of tighter monetary policy. However, the GBP has thus far failed to strengthen in reaction to the market’s changed interest rate outlook.

The UK Office for National Statistics recently confirmed its preliminary reading of Q1 2008 GDP at +0.4% qoq, which translates into +2.5% yoy. This compares to the +0.6% qoq seen in both Q4 and Q3 2007. The slowdown in economic growth was most pronounced in the category of business investment, as firms anticipate a slow period of growth ahead and feel the ongoing effects of the credit crunch. The main pillar of growth was domestic consumption. However, British consumers are likely to decrease spending throughout the remainder of the year, as they face the headwinds of declining house price appreciation (and the potential for outright declines) and real incomes being eroded by rising levels of inflation, stoked by surging energy and food costs. Indeed, the latest reading of GfK UK consumer confidence (for April) revealed a decline to -24 from -19 in March. This was the lowest reading since November 1992, when the UK economy was pulling out of its last recession. Market looks for 2008 GDP growth to come in at 1.7%, a dramatic slowdown from 2007 GDP growth of 3.0% and well below the trend rate of 2.5%.

However, rising inflationary pressures will likely force the MPC to keep interest rates on hold in the UK throughout Q2 and Q3 2008. April headline CPI rose to 3.0% yoy from +2.5% yoy in March, well above the BoE’s target of +2.0%. The core rate firmed to 1.4% yoy from 1.2% in the previous month. In addition, inflationary pressures remain in the pipeline with producer prices rising 23.3% yoy in April – the highest level in more than two decades! Inflation is also being stoked by rising wage demands. The March average weekly earnings data showed a yoy gain of 4.3%. While this is below the 5.1% seen only six months ago, it marks a rise from the 3.9% seen in February and is just below the 4.5% yoy level of wage growth identified by the BoE as consistent with price stability. In the aftermath of the MPC’s decision (8 to 1) to leave rates on hold at 5.00% at its May 8th meeting, which followed several weak data points, the market drastically shifted its interest rate expectations. However, the TWI GBP has not yet reacted to the sharp change in UK interest rate expectations, as the deterioration in the economic data, especially the weakening housing market, continues to weigh on the currency.

Nonetheless, the risk is that the mis-pricing will eventually correct itself, and the GBP sell-off has now run its course. On a bilateral basis, one of the greatest divergences amongst the G10 currencies between developments in the interest rate swap markets and the currency markets is between GBP and NZD. The key two-year interest rate swap spread suggests the pair should be trading around 2.8600. Moving forward, look for favorable opportunities to establish a long GBP/NZD position, consistent with the negative NZD outlook.