Uptick in GDP gives GBP a boost so what next for the BOE

The UK economy grew at a quarterly rate of 0.4% last quarter, beating expectations of 0.3%. This was the fastest quarterly pace of growth so far this year, but is still below the 0.6% rate registered in the last quarter of 2016. The initial market reaction was a spike higher in sterling to 1.3170, partly reversing the 0.9% decline in the pound on Tuesday. Overall, it seems like the FX market was pricing in bad news ahead of the GDP report, they were caught off guard and are now playing catch up, which could see GBP/USD retake the 1.3200 level in the coming hours.

Manufacturing makes a comeback as Construction slips into recession

This was the first reading of UK Q3 GDP, so the report is fairly sparse on detail. The office for National Statistics (ONS) reported that services, the largest sector of the UK economy, rose by 0.4%, the same rate as Q2, with a particularly strong performance in computer programming, motor trade and retail trade. Manufacturing was a major bright spot, rising 1% in Q3 after a very weak Q2, which now looks like a blip. However, the good news stops there as the construction sector in the UK is now technically in recession, having suffered its second consecutive quarterly contraction, but the ONS pointed out that construction remains well above its pre-downturn peak, suggesting that this slowdown is a natural occurrence and does not forecast weakness in the larger sectors of the economy.

This data goes some way to counter the very weak retail sales data from last week. Retail sales fell some 0.7% in September, but according to the ONS that hasn’t dented the annual impact from retail trade at this stage, however, it could bode ill for Q4, a traditionally strong quarter for retail sales. Thus, even though this data suggests that the UK economy isn’t faring as badly as some thought, there are still headwinds that could knock the UK economy off course.

GDP and the BOE:

The big question is where this leaves the Bank of England, which is expected to hike interest rates by 0.25% at its meeting next week. There is now an 85% chance of a hike priced in by the UK interest rate futures market, this is up a touch after the GDP report from earlier. If the BOE fails to hike then it could lose its credibility or be accused of leading the market up the garden path. However, although the GDP data was better than expected it is not strong and there are pockets of weakness that could come under even more pressure if the BOE does hike interest rates, such as the construction sector.

This is not an easy decision for the BOE, as we have mentioned before, however, our base case is that the BOE does hike rates next week, but signals that it will leave a long time, say 9-12 months, before doing so again. This could cause the pound to drop, as right now the market is betting on the prospect of two rate rises for 2018, which we believe is too optimistic.