Jobs, Not Inflation, Will Drive U.K. Rates

NEW YORK ( TheStreet) -- Against the dollar, the pound is trading at its highest levels in eight months. Recent rallies have been driven by minutes from the September meeting at the Bank of England, where policymakers voted 9-0 decision to keep stimulus programs on hold.

This is a significant difference from what was seen during the August meeting, when a dissenting minority saw a "compelling" need for policy changes that were more accommodative.

This is also an implicit suggestion that the BOE is confident that improving macroeconomic data indicate a sustainable trend.

The reduced potential for additional monetary stimulus has pushed the pound to gains of nearly 7% since the end first quarter, which is one of the best performances we have seen this year in developed-market currencies.

But, at the same time, it should be noted that the currency is still down nearly 30% from its 2007 highs against the dollar. At this stage, it is clear that in order for pound rallies to sustain themselves, we will need to see higher yields and a commitment to raising interest rates. Without this, the pound is in a precarious position and vulnerable to large moves to the downside given the strength seen in the last few months.

Supportive Data

To be sure, economic data largely support the Bank of England's more hawkish stance. The economy in England, the third largest in Europe, is expected to expand 1.3% in 2013 and by 2% next year.

This is slightly less than the GDP expectations for the U.S., where expectations rest at 1.6% for this year, and 2.7% for 2014. But England's August Purchasing Managers' Index (PMI) report showed that the service sector grew at its highest rate since 2006.

A broader measure, the Citigroup Surprise Index (which tracks positive and negative results in all economic releases, relative to market expectations) has risen to 72 this month after hitting lows of -33 in May.

But if we are going to see the higher interest rates needed to sustain long-term rallies in the pound, we will need to see the U.K.'s unemployment rate fall below the central bank's target of 7%.

Rate Expectations

Over the last decade, BOE decisions to raise interest rates have generally been based on surges in consumer price inflation, which in some cases have reached levels many would consider excessive for a developed economy.

Current policy goals at the BOE set the inflation target at 2% using a two- to three-year time horizon. But most recent comments from Governor Mark Carney suggest that the BOE has shifted focus and is much more concerned about the state of the labor market. In the three months through July, unemployment in the U.K. dropped to 7.7%, which is still well above the central bank's target. In order to reach the 7% goal need to see any changes in interest rate, the U.K. would need to create more than 750,000 new jobs.

All of this means that we still have some way to go before the BOE is likely to make a true commitment to rising rates. The pound at its elevated levels will be without a true bullish driver until we see the added incentive of higher yields for long-term positions.

And when this stronger pound is taken into consideration along with the increased chances of reduced stimulus from the Federal Reserve, the pound is likely to experience some downside corrections into the final months of the year.

At the time of publication, Cox had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Richard Cox is based in China, and has lectured at several universities there on international trade and finance, focusing primarily on macroeconomics and price behavior in equity markets. His articles appear on a variety of Web sites, including MarketBulls.net, Seeking Alpha, FX Street and others. Investing strategies are based on technical and fundamental analysis of all the major asset classes (stock indices, currencies, and commodities). Trade ideas are generally based on time horizons of one to six months.

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