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Forex: Sterling – self assured

The following is an extract from our quarterly outlook, published 23rd June 2014.  I’ve included a table of forecasts at the foot of the blog.

Many factors affect currency valuations, but interest rates, both actual (principally via carry) and expectations for future changes (e.g. via 2 year rates) are the one thing that invariably stand the test of time.  Back at the end of 2013, the prevailing view was that the US would be putting up interest rates before the UK, thanks in a large part to the adoption of forward guidance by the Bank of England.

Of course, time will tell, but currently the market expects the UK to move first, with pricing currently suggesting the first UK rate hike in Q1 2015. In reality, we expect it to come in November this year. Recall that the US was the first to fall, they cut rates earlier and faster than the UK and the economy hit the pre-cycle peak in output a full 3 years before the UK, which has only just achieved that. The main difference was the labour market, the UK holding up well (although productivity falling), the US suffering a damaging reversal from which it has still yet to fully recover from.

Even if rates do rise, we are talking only a quarter of a point and a gradual tightening cycle thereafter. As such, the currency implications should not be over-played.  For cable, we should see it capped by the 1.75 level for the remainder of the year.

And let’s not get carried away in thinking that all is well with the UK economy. The external sector (current account as % of GDP) continues to deteriorate, not that far off levels last seen in the late 1980s. Furthermore, wage growth continues to be weak and only just keeping up with inflation.  But growth is likely to touch near 3% this year, so a cautionary rate hike remains warranted.

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