- Sterling was among the top performing currencies last year…
- …it remains one of our top picks this year against the euro…
- …reflecting likelihood of sustained strong growth and favourable monetary policy differentials
Sterling among the strongest currencies in 2013
In 2013, sterling (GBP) was among the top performing currencies in our coverage, with only the euro and the Swiss franc recording a better performance. Since the start of this year, its performance has been mixed. It has outperformed the Canadian dollar, Swiss franc, Norwegian krone, euro and Australian dollar but underperformed the Japanese yen, New Zealand dollar, US dollar and Swedish krona. This year sterling remains one of our top picks against the euro, on the view that the UK economy will outperform, while the BoE is likely to be the first major central bank to hike rates.
Economy looks set to remain strong…
The UK economy has been firing on all cylinders. Economic growth rose by a quarterly annualised rate of more than 3% in both Q2 and Q3. This compares to average growth of less that 1% in the eurozone over the period. Recent indicators suggest that the economy may have done even better in Q4, accelerating by more than 4% on an annualised basis, while we estimate that eurozone GDP growth continued to trend in line with the lacklustre growth rates seen previously.
…on buoyant domestic demand
We expect the UK economy to continue to outperform going forward. Domestic demand looks set to remain buoyant. Leading indicators for the housing market point to an ongoing acceleration in house price growth in the coming months. For instance, the RICS house price expectations balance rose to +61 in December from +59 in November, taking it to the highest level since September 1999. At current levels, the indicator suggest that house prices could accelerate to annualised rates of 20% or more. Such strength in the housing market supports consumer demand, as it drives up household wealth, as well as residential investment. Meanwhile, consumer demand is also benefiting from a strengthening of the labour market recovery. Employment growth is accelerating, while unemployment is falling rapidly. This should start to lead to stronger wage gains before long, while real household incomes are already benefiting from the fall in inflation. Last Friday, retail sales surprised on the upside with a m-o-m increase of 2.8% (6.1% y-o-y) surpassing expectations of 0.3%. Overall, we expect UK GDP to grow by 3% this year, compared to 1.3% for the eurozone.
BoE may well be the first to tighten its policy
The strength in the economy will likely lead to the BoE to be the first major central bank to hike its policy rate in our view. The current momentum in the economy and the housing market would in the past have already been enough to get the majority of MPC members considering tighter monetary policy. However, the Committee as a whole seems set on giving the economic recovery a chance to get established and appears happy to accept somewhat higher inflation over the medium term to do so. In addition, its first port of call in terms of cooling the housing market is likely to be direct macro prudential policies to restrict mortgage lending. However, by early 2015, we think that a string of strong quarters of growth and a sharply lower unemployment rate will trigger the start of a UK rate hike cycle.
Financial markets already anticipating UK rate hikes
It must be noted that interest rate futures markets have already moved a long way to price in a relatively early rate hike cycle, so to some extent the above views on UK monetary policy are already partially reflected in the sterling exchange rate. On the other hand, we think that financial markets are still underestimating how accommodative ECB policy will likely be this year and next. We expect it to move to ease policy before long and we think that the upward trend in Euribor rates implied by next year in futures markets is unrealistic.