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When It’s That Obvious I Get Worried!

The scene is set for the European Central Bank (ECB) to either increase quantitative easing or lower the Repo rate at their meeting in December or a more likely scenario is that they will do both. Meanwhile in the UK, the Bank of England (BOE) have been rowing back on their guidance that UK interest rates would rise around the turn of the year, they are now indicating mid-2016. This is still providing support for the pound as interest rate divergence continues to weaken the Euro and absolute interest rate levels (UK Base Rate is 0.5%) encourage flows into Sterling.

Meanwhile the US Federal Reserve (Fed) seem a nailed down certainty to raise US interest rates at their December meeting and most commentators expect this to lead to a stronger US Dollar (in particular against the Euro) into 2016. Traditionally we would expect Stg in such circumstances to also make gains versus the Euro and initially I expect that to be the case.

“do not raise rates”!

However the decision to adjust monetary policy is likely to be a more difficult one for the Bank of England than for the Fed or the ECB. Some UK economic indicators are screaming “do not raise rates”! These include the CPI rate which stubbornly refuses to rise (it’s been around 0% for most of the year-0.1% in November) and UK Pay growth that remains tepid at best despite an unemployment rate of 5.4%. It would not take much of a stretch of the imagination, if at the end of the first quarter 2016, the BOE were to revise their guidance to raising rates by year end, does this sound familiar?

EURGBP (yellow) and CPI month on month (white) historical chart over the past 2 years, Source: Bloomberg

EURGBP (yellow) and CPI month on month (white) historical chart over the past 2 years, Source: Bloomberg


What all this means is that the domestic economic case for raising UK interest rates is questionable at best and the case for a stronger Stg is largely dependent on higher rates.

The global economic elephant in the room is do we get a soft or hard landing in China in 2016? While the recent economic data from China is indicating a soft landing, it is far too early to discount a less benign scenario. To paraphrase Robert Burns “the best laid plans of mice and men often go askew” If China was to undergo a hard landing then one cannot see the BOE raising rates and Stg under those circumstances would likely give up its gains.

The Brexit vote

Leaving aside the economic factors for a moment; if we turn to the political arena we have the UK’s own moment of truth that could well be resolved in 2016 – the Brexit vote. Is the UK likely to leave the European Union? It’s impossible to say but it is likely to lead to increased uncertainty and unease at holding Stg.

So where should we expect Stg to trade against the Euro for the remainder of 2015 and into 2016? I am certainly foolish to even hazard a prediction, however ignoring that truism, I can see Stg benefiting from expected ECB easing in December, testing the .6800 to .7000 band in the run-up to the year end. I expect that may be the low point for the Eur/Gbp and thereafter I see a slow drift higher towards 0.7500 by the end of Q2 2016 at which point the Brexit debate should be to the forefront of the Market’s thoughts.
As always I welcome alternative views or comments.

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