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The pound is at a 6-year high versus the USD again today as the UK‘s construction sector PMI beat expectations and rose to its highest level for four months. This is the second consecutive positive data surprise in as many days and points to robust GDP figures for Q2. So can the GBP rally last?

Factors that could drive sterling going forward:

Positives:

• Growth is still strong, and we could see a continued acceleration in the second half of the year, which could support the pound.
• Yield is a key driver of currency strength. As you can see in the chart below, the profile of the UK’s sovereign curve is above that for the Eurozone, Germany and the US, which is also pound supportive.

Negatives:

• • The housing market. After last week’s FPC measures, the risk of a slowdown is rising, which could delay rate tightening from the BOE. See more below.
• • Political stability is another factor that can drive a currency. For now, the UK government is stable; however, this is one of the biggest risks facing the pound, in our view. Although unlikely, if Scotland votes yes to independence on September 18th then sterling could struggle amidst political uncertainty.

Sterling and the housing market:

The housing market could be the most critical factor for the pound going forward. Last week the Financial Policy Committee announced new macro prudential measures to try and reduce pressure on the housing market. These measures, which were designed to reduce leverage ratios, were considered fairly toothless by the market, and the swaps market is still expecting a rate hike at the start of this year.

Some are calling for a rate hike as early as November, as the BOE succumbs to pressure and hikes rates to deflate a potentially damaging housing market bubble.

However, this is far from set in stone, and here are a few risks to this scenario:

1. If the BOE starts treating these macro prudential measures as a substitute for monetary policy action then a rate hike may not be as forthcoming as some imagine.
2. Although Nationwide house prices showed an 11.8% annual rise across the UK for last month, there are other signs that show a slowdown in momentum in the housing market. Mortgage approvals fell to their lowest level since July 2013 in May, which suggests that banks’ are scaling back lending activities, particularly in high risk areas like London. If this continues, then there could be less impetus for the BOE to hike rates by the end of this year.

It’s been some time since the housing market had such an impact on the UK currency, but it could be the key driver of sterling going forward, as it could determine the timing of the first rate hike from the BOE.

As it stands, the bigger risk right now is that rate expectations get pushed into the future, not brought forward. If the FPC’s measures do work, and we see a slowdown in the housing market, then the BOE could be justified for not raising rates, as the UK’s economic recovery can ill-afford headwinds from any sector of the economy right now.

While the headline-grabbing price gains in the housing market tend to make the front pages, the BOE (and smart market participants) should looks at the granular housing market data, such as mortgage approvals, which continue to show a slowdown.

While this is not thwarting sterling’s rally so far, we think that it is vulnerable to a set-back if we see weak housing data in the coming months.

Takeaway:

• Growth and yield differentials are supporting this pound rally right now.
• However, political stability could hurt the pound as the Scottish referendum comes into view in September.
• The housing market is a major risk factor for the pound going forward. If the BOE starts to use macro prudential measures instead of rate hikes to influence monetary policy then the pound could be at risk from a sell off.
• Although house price growth continues to gather pace, there is more granular evidence that a slowdown could be coming, including a 10-month low in mortgage approvals (see figure 2).
• Going forward, housing market data might become the most important economic data for GBP traders.

Figure 1:

Source: Bloomberg and FOREX.com

Figure 2:

Source: Bloomberg and FOREX.com

Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient.

Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

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