UK: Dark Economic Clouds Loom Larger in 2009

As my colleague Fernand Kong mentioned in last month's FX Outlook, the USD recovery in the latter half of 2008 was the result of the near collapse of the global financial system. This environment fueled the unprecedented global appetite for dollars in the form of forced liquidation of non-dollar FX positions, local repatriations and the unwinding of non-dollar investments. The December FX flows continued to illustrate extreme market volatilities as the major G-10 global central banks were forced to make emergency-driven policy adjustments to combat the worsening global slowdown that some are now predicting will lead to massive deflationary pressures down the road.

As 2008 closed out (thankfully!), the U.S. Fed and the UK's Bank of England (BOE) in particular were under intense pressure to rapidly ease local interest rates as the asset and debt markets began to fully digest the many implications of their aggressive monetary policy responses. In Euroland, the EUR benefited somewhat from the relatively cautious European Central Bank's (ECB) approach to the crisis as it unfolded in 1H08. However, as 2009 began, the bleak condition of the various Euroland economies may ultimately force the ECB's hand to continue lowering rates in an effort to stem the evolving Euroland recession.

What the Numbers Show
Many believe the economic conditions in the UK are pointing to a more severe contraction in GDP in 2009, as the current recession should prove to be more severe than the last prolonged downturn in the early 1990's. Investment and consumption levels are likely to be the biggest drags on overall growth, and can be directly linked to the general collapse in the housing market (very similar to the U.S.) as illustrated in recent domestic data. Industrial and manufacturing production has recently fallen by 5.2 percent and 4.9 percent respectively due to collapsing global demand. The corresponding labor market prospects will most likely continue to deteriorate substantially. The unemployment rate is expected to rise to over nine percent, which will exacerbate the drag on consumer spending and related consumer confidence. Ironically, the sharp depreciation of the GBP since the summer of '08 can be pointed to as a positive influence for the country's growth outlook going forward. The other side of the cheapening UK export story is finding overseas demand in the current weakening global environment, but the depressed currency should buffer the "perfect storm" effects of the current crisis.

Headline CPI inflation rates for 2008 peaked in the UK over the summer at 4.7 percent in August, which was the highest level since 1997. But as overvalued commodity prices (primarily oil) took a fall from mid-July, the recessionary landscape began to take shape. The dramatic drop in the CPI since last summer has, in fact, led to the possibility of overshooting the lower level of the BOE's target range, with the possibility of ending this year below one percent. A disinflationary environment that could follow later this year is thought to be linked directly to the dramatic slump in energy and food inflation, and could overtake the effects of the current recession dictating ever-lower inflation rates.

The BOE Takes Action
As the current global crisis took hold in mid-2008, the BOE demonstrated that it would take the threat of a severe recession very seriously. That view was reflected in the last few months of 2008, as the central bank lowered local interest rates by a total of 300 bps in the last three meetings of the year - 150 bps on November 6, 100 bps on December 4, and another 50 bps on January 8, 2009 - to the present 1.5 percent (the lowest interest rate level in the UK since 1694!). As in the U.S., the positive effects of the dramatically lower bank rates are not being fully felt at the consumer level in the form of cheaper mortgage and short-term credit rates, and on business side via lower borrowing costs. Going into 2009, the BOE might be forced to follow the Fed's lead and bring rates down closer to zero percent as it attempts to force banks to finally reduce rates and lend money again. Nominal GDP growth will ultimately provide the guide to where the BOE's eventual policy rate should be as the current recession progresses. As a point of reference, GDP in 2007 was a solid three percent via corresponding interest rates at 5.5 percent. Full-year 2008 is projected to end up at 0.8 percent via the current two percent level and 2010 is expected to be an anemic -2.1 percent. As previously mentioned, rates are expected to be in the zero to one percent range if the current pressures persist. On the political front, the popularity rates of PM Brown and Chancellor of the Exchequer Darling have gone from bad to worse, with the anemic economic and disjointed financial market conditions likely to continue to weigh on their approval ratings.

Apart from the USD, the EURGBP cross continues to trade near parity as the FX market anticipates UK rates will continue to be lowered by the BOE, reflecting the deepening recession. The current debate on the direction of the cross is whether all of the Euroland bad news is built into the rate. But as the year progresses, the oversold EURGBP cross may reflect stronger GBP levels than currently seen if the ECB surprises on the downside and eases more than currently expected. Against the USD, the direction of the GBP is still seen as trading a bit lower from current levels. The current forecast rates for GBPUSD as posted by Bloomberg (to which SVB contributes) are 1.46 for Q1 2009, 1.48 for Q2, 1.48 for Q3 and 1.52 for Q4.

A Look Ahead
As we enter the new year, the global economic landscape remains in disarray, elevated volatilities continue to result in two to three percent daily FX swings and questions remain about what will actually materialize once the massive central bank monetary programs coming fully online later this year. The UK enters the year on weak footing, with expectations for the local fundamentals to remain benign, but the oversold currency could eventually have a very positive effect on working through this nasty global environment.