As part of Finance Monthly’s brand new fortnightly economy and finance round-up analysis, Adam Chester, Head of Economics & Commercial Banking at Lloyds Bank, provides news and opinions on UK and global markets touching on the Bank of England, Brexit and currencies.

The pound fell to an eight-year low against the euro over the past week, pushed by ongoing signs of momentum in the Eurozone and concerns over the outlook for the UK economy.

Sluggish wage growth has also fuelled concerns about the strength of the economy as a whole.

The Office for National Statistics reported that average weekly earnings grew by 2.1% year-on-year in the three months to June - equating to a 0.5% fall in real wages.

While there can be little doubt that the fortunes of the Eurozone have improved, despite Brexit uncertainty, the fall in the pound looks overdone and the UK’s position could now be shifting.

Signs of improvement

The jury remains out on the extent to which Brexit uncertainty is weighing on sentiment, but earlier indications of a sharp slowdown in economic growth have given way to signs of stability.

Undeniably, the economy slowed sharply in the first half of this year. Quarterly GDP growth averaged a below-trend 0.3% across the first six months of 2017, compared with 0.6% in the second half of 2016.

As the third round of Brexit discussions gets underway however, reports including CBI industrial trends, purchasing managers index (PMI), labour market and even retail sales are all showing signs of improvement.

While plenty of downside risks remain, for now, households and businesses are in the main managing to cope with the challenges.

Employment and exports climb

Take the latest employment report, for example.

According to the ONS, total employment rose by a further 125,000 in the three months to June, pulling the unemployment rate down to 4.3% - the joint lowest rate since 1975.

Separately, the CBI reported last week that industrial orders rose this month, approaching the 29-year high seen in June. The trade body stated that a rise in both domestic and export orders was behind this rise, with the latter fuelled by the drop in the pound and the turnaround in the Eurozone’s fortunes.

Improvements didn’t stop there. The latest UK public finances data were also better than expected. July’s public finances were back in the black for the first time since 2002, thanks to surging tax revenues.

The beleaguered retail industry also saw a return to stability. Sales rose by 0.3% in both June and July, though this could prove temporary, as the latest CBI retail trades survey suggests renewed weakness in August.

Brexit and the Bank of England

Despite these signs, Brexit uncertainty still looms large.

At its policy meeting earlier this month, the Bank of England remained studiously agnostic on the implications of Brexit. For forecasting purposes, it assumes a “smooth transition” post March 2019, but makes no judgement about what form the UK’s eventual relationship with the EU may take.

It’s clear, however, that uncertainty continued to weigh heavily on the minds of UK rate-setters when they left the bank base rate unchanged again this month by a margin of 6-2.

Alongside this decision, the bank published its inflation report, containing modest downward revisions to GDP predictions for this year and 2018. Inflation is expected to remain above its target of 2% over the next three years.

Judging by the reaction, these latest communications have been taken as evidence that UK interest rates will remain on hold for a long time.

The markets are not priced for a first quarter-point rise until mid-late 2019, and the rate is expected to be below 1.0% in five years’ time.

Potential rate rise earlier than expected

But this looks overdone.

Market participants seem to have focused on the most dovish aspects of the Inflation Report, ignoring the explicit warning the rate may rise more sharply than the market yield curve expects and forgetting the implications of the ending of the Term Funding Scheme (TFS).

The programme has been in place since last August to help provide cheap finance to the banking system.

It would be odd to increase rates while at the same time mitigating the impact through TFS, so when it ends next February an obstacle to an early rate rise will have been removed.

On balance, the recent scaling back in UK interest rate expectations, and the corresponding impact on the pound, may have gone too far. There remains a significant risk that the first rise comes earlier than the market expects – possibly by early next year.

Much will depend on how Brexit negotiations develop. One thing is certain, the markets will be watching closely for any signs of progress.

As part of Finance Monthly’s brand new fortnightly economy and finance round-up analysis, Adam Chester, Head of Economics & Commercial Banking at Lloyds Bank, provides news and opinions on the rise in inflation, the UK’s weakness in productivity, and employment & GDP.

The anniversary of the UK’s decision to withdraw from the European Union has now passed, and who could have imagined the political fallout that would ensue?

One year on, the formal Brexit negotiations have only just begun, yet the nature of those negotiations and their ultimate destination remain unclear.

Despite all this uncertainty, it is remarkable how well business sentiment and the economy has held up.

The resilience of the UK economy however, and UK financial markets, has prompted a very different response from the Bank of England than the one that followed the EU Referendum.

While the bank came out ‘all guns blazing’ last summer, the focus now is on when it will start to take that stimulus away.

Doves taking flight?

Bank of England officials have signalled that above-target inflation may not be tolerated for much longer.

Even Governor Carney – one of the more dovish members of the UK rate-setting committee – has rowed back a little on his earlier stance, suggesting that if the balance between growth and inflation continues to shift, ‘some removal of monetary stimulus’ is likely to be necessary.

The markets now have the August MPC meeting in their sights. That is when the Bank of England takes another detailed look at its GDP and inflation forecasts.

By then, not only is inflation likely to be much higher that the bank was previously forecasting in May, but the committee may also have to factor in the risk of some loosening in fiscal policy.

The decision will come down to the MPC’s assessment of the trade-off between growth and inflation.

BoE Deputy Governor Broadbent noted in a recent  interview that there were many ‘imponderables’ and that he was ‘not ready’ to support a rate hike.

Meanwhile, Ian McCafferty underscored his credentials as the most hawkish member of the BoE’s rate-setting committee, arguing not only for an immediate quarter-point rise in interest rates, but also for the BoE to consider reversing its money-printing programme earlier than planned.

The productivity problem

While all eyes are on Brexit, it is easy to miss what is arguably an even bigger challenge for the UK – the weakness of productivity.

UK productivity (as measured by output per hour) contracted by 0.5% in the first quarter of this year, leaving it at its lowest since before the 2008 financial crisis.

By any measure this is a shocking performance.

There are various explanations for the UK’s disappointing productivity, and some are more benign than others.

Part of the reason may be simple mismeasurement. Recording the productivity of economies such as the UK with large service-sector industries, particularly financial services, is inherently difficult.

As the UK’s official statistics indicate, productivity in some sectors, including financial services, has performed significantly worse than other non-financial service sectors over the past decade. But this does not tell the whole story.

Productivity may have also deteriorated due to changes in the composition of capital and labour.

Since the financial crisis, low wage growth and heightened economic uncertainty may have encouraged more companies to hire new workers to drive output growth rather than undertake productivity-enhancing capital investment.

Going for growth

The rise in the UK’s GDP over the past decade has been driven, almost exclusively, by increases in employment and hours worked.

The UK’s latest labour market data underscores this point. Total employment grew by a stronger-than-expected 175,000 in the three months to May, while the unemployment rate dropped to a new multi-decade low of just 4.5%.

At the same time, pay pressures remain benign, with annual growth in overall pay slipping from 2.1% to 1.8% - the first time it has been below 2% since February 2015.

Based on current data, GDP is likely to have expanded by 0.3% in the second quarter, while total employment is predicted to have risen by 0.3%. As a result, productivity growth is projected to be zero.

The combination of a tightening labour market, weak productivity growth and benign pay pressures pose a major dilemma for the Bank of England.

For now, we expect the Bank to keep its powder dry, but it won’t take much further sign of economic strength to persuade it to reverse last August’s quarter-point rate cut.

As part of Finance Monthly’s brand new fortnightly economy and finance round-up analysis, Adam Chester, Head of Economics & Commercial Banking at Lloyds Bank, provides news and opinions on volatility in the uncertain market and the prospect of a hike in interest rates, both in the UK and the US.

Clearly, the last two weeks have seen political shocks with potentially far-reaching consequences for the UK’s economic outlook.

The aftermath of the General Election has introduced new uncertainty over the implications for Brexit though, so far, financial markets have taken it in their stride.

However, until there is a clearer sense of what the new minority government can achieve, UK financial markets and the pound are likely to be prone to sharp bouts of volatility.

Three wishes

The outlook for the UK’s Bank Rate seems to be changing by the moment.

The surprisingly close June vote on interest rates by Bank of England policymakers saw three of the rate-setting committee back a rise.

Governor Carney seemingly attempted to put a lid on the discussion by stating that now was not the time to raise rates. However, Andy Haldane, the Bank’s Chief Economist, subsequently said he was now close to voting for an interest rate hike.

This is particularly significant as, until now, Haldane was considered to be the arch dove amongst the Bank’s rate setters. Moreover, it is the first sign of a divergence in views between the current permanent Bank employees on the committee.

Up until now it’s only been the so called external members who have voted for a hike. Is that about to change?

Markets certainly think there is something new in the air, as can be seen by the implied probability now put on a 2017 interest rate hike. That has gone up from below 10% just over a week ago to about 50%.

What is most surprising about this sudden shift in expectations is that economic conditions are arguably little changed.  Once you also factor in political uncertainty, including the unexpected result of the general election, then on the face of it, the case for staying put seems strong.

But the hawks amongst Bank rate setters had previously indicated that they have limited tolerance for above-target inflation.

Close to the limit

Two factors suggest that the limit may be close to being breached.

First, Kristin Forbes, one of the hawks, has noted in recent research that the effects of an exchange rate generated inflation shock can persist. This questions whether the Bank is right to prioritise domestic pressures.

Second, the eventual impact on wages of what looks to be an increasingly tight labour market remains a concern. The UK unemployment rate is now at its lowest level since the mid-1970s and there are signs that this is having an impact.

On balance, we expect the Bank to keep interest rates on hold for now. Nevertheless, this is a closer call than for some time.

Over the next few weeks, markets will be paying particular attention to any comments from those Bank policymakers who have yet to make their position clear.

It will be an interesting run up to the next policy announcement on 3rd August.

Fed up again

In the US, a quarter-point rise in interest rates was widely expected, and subsequently delivered.

The Federal Reserve also stuck to its previous ‘dot plot’ forecast to raise interest rates, anticipating another quarter-point rise this year, and three more in 2018, with the key policy rate expected to settle around 3.0% in 2019.

In pre-announced plans, the Fed intends to start unwinding its balance sheet. For the moment, it anticipates deflating its asset holdings by $10bn a month from later this year, rising in small increments every three months to $50bn

Despite this, US financial markets may have other ideas – as they continue to pretty much ignore the Fed’s guidance. The markets are only fully priced to one more quarter-point rise by the end of next year.

With signs of more mixed growth emerging recently and a weakening of core inflation, the markets clearly think the Fed has got it wrong.

This misalignment can only last so long. Either the Fed will have to eat humble pie, or the US, and by extension global, bond markets could be in for a much more testing second half.