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On the eve of the UK GDP release for the first quarter that will confirm whether or not the UK managed to avoid a technical recession, it is worth taking stock of the actual strength of the UK economy as move towards the middle of the year.
Overall, the biggest disappointment so far this year has been construction data, which may have contracted by approximately 10% in the first quarter. Construction is roughly 7% of UK GDP, so a contraction of this size could easily dent overall growth figures. Close behind comes industrial and manufacturing data. IP fell at a 2.3% annual rate in February and manufacturing data has declined four months out of the last five. Although the pick-up in PMI data suggests that things may have improved in March, the industrial and manufacturing sectors have been in steady decline since peaking in mid-2010.
The bright spot in the data was retail sales, which increased at a 3.3% annual rate in March. However, retail sales have a fairly weak relationship with the measure of consumption in the national accounts data, so this gain may not be reflected in overall GDP.
We believe that the UK economy will (just about) register growth in the first quarter of this year, thus narrowly avoiding recession. However, the UK is still in a precarious position and faces both internal and external threats.
The obvious external threat is a deterioration in the sovereign debt crisis. The peripheral sovereign debt market in Europe has stabilised after wobbling earlier this month, but weak growth in the periphery and continued sovereign strains are a major threat to the UK's export market.
UK financial woes
The internal threat is our own public sector spending. February and March delivered some nasty surprises regarding the public sector debt levels. Public sector borrowing in March was up by GBP18.2bn, higher than the GBP16 bn expected by the market. Although this was the second consecutive disappointment, the government still met its debt forecast for the year of GBP126bn, down from GBP136.8bn last year. However, the March borrowing figures still put the UK's public sector debt levels above the GBP1 trillion mark. Although public sector spending excluding benefits and interest fell slightly, the first fall since 1955, it is still going to be a challenge to meet the government's borrowing target for this year of GBP120bn.
The government is still spending more than GBP388bn per year, and the bulk of the spending cuts in the UK economy are actually back-loaded and expected to take place in the last two years of the current parliament. Either the government expects us all to get used to austerity over the next three years or we should expect the fiscal goal posts to be moved in the coming years.
For traders the public sector finances are important for a couple of reasons: 1, a weak economy could boost benefit payments and make public sector spending even harder to bring down and 2, any fiscal slippage could cause the UK to lose its triple A credit rating, which it has managed to hold onto even though the US and France recently both lost their top credit rating.
An increasingly less dovish BOE
The market expects Q1 GDP to expand by 0.1%, a fairly lacklustre quarter. But this hasn't stopped the Bank of England from getting increasingly less dovish in recent weeks. Even former uber-dove Adam Posen changed his stance at the last BOE meeting earlier this month and voted to keep rates and asset purchases on hold. This is significant - Posen is no longer talking about more QE and instead sounding worried about inflation.
While official growth figures are likely to skirt along the bottom for at least the next couple of quarters, the BOE has said that GDP data is likely to underestimate the underlying strength of the UK economy. The Bank's justification for its shift in stance from the dovish side to the fence is based on an on-going economic recovery and stubborn inflation pressures. This change in stance has helped to buoy GBPUSD above 1.6060 and EURGBP below 0.8200. But if growth surprises to the downside tomorrow or data starts to turn lower in the coming months, this could jeopardise the BOE's more hawkish stance, which could weigh on the pound.
Added to this, we don't believe there will be higher rates in the UK any time soon. The BOE will need to fill in the growth gaps caused by fiscal consolidation, which as we state above remains very incomplete at this stage.
What does this mean for the pound?
The strength of the pound has, at times, seemed disconnected with the UK economy. Instead it has been trading on the back of safe haven flows out of Europe and into the UK Gilt market. The 10-year Gilt yield is close to its lowest ever level as investors seem to be piling into the UK because it's not part of the Eurozone.
The pound has been one of the best performers in the G10 FX space along with the CAD, due to the hawkish stance of their respective central banks. These currencies have performed extremely well against currencies with dovish central banks including the Aussie, the Nok and the yen. To a lesser extent they have also performed well versus currencies with central banks that remain very firmly on hold including the EUR and USD.
GBPAUD is definitely worth watching. It is approaching a key resistance level at 1.5625, the 61.8% Fib retracement level from the Oct 2011 high to the mid Feb 2012 low. Above here opens the way to 1.60 in the medium-term, the high from the end of November 2011. The Aussie is losing its attractiveness as a carry trade due to the expected RBA rate cut, so we could see GBPAUD continue to perform well in the lead up to the May RBA meeting when we should get some direction on whether the RBA will embark on a rate-cutting cycle.
Unless we see 1, a negative surprise in UK GDP data tomorrow or 2, a dovish tone to BOE commentary (both of which we deem low probability events) then this pair may continue to do well in the short to medium term. However, support lies at 1.55 then at 1.5440 - the 50% Fib level mentioned above.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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