Continued improvement in the labour market paves the way for a rate hike later this year

The UK labour market report released today shows that the labour market is continuing to improve although at a slower pace compared to the beginning of 2014. The ILO unemployment rate (3M) in December declined further to 5.7% from 5.8% in November (Danske Bank Markets: 5.8%, consensus: 5.8%) and has fallen by 0.3 percentage points since October. The last time the unemployment rate was this low was in August 2007.

The number of unemployed has declined by 97,000 from Q3 to Q4. Employment is up by 103,000, while the number of economically active people increased by 6,000. The fall in the claimant count level indicates that unemployment will continue to fall in the coming months.

We are not far from the Bank of England’s estimated medium-term equilibrium unemployment rate at 5.5%. According to projections from the Inflation Report released last week this could be the case as early as Q2. This indicates that the slack in the labour market is diminishing. The Bank of England estimates that the slack is in the region of 0.5% of GDP.

Average weekly earnings excluding bonuses (three-month average) declined to 1.7% in December from 1.8% in November. Although this is the first decline since June 2014, we do not expect this to be the start of a new downward trend. Going forward, wage growth should be supported by the declining degree of slack in the labour market. Keep in mind that real wage growth is positive, despite the low wage growth, due to the low inflation which supports private consumption.

The Bank of England (BoE) also released the minutes from its February meeting today. The Monetary Policy Committee (MPC) voted unanimously in favour of keeping the Bank Rate and the stock of purchased assets unchanged at 0.5% and GBP375bn respectively. However, the MPC has become more divided below the surface. For two members (most likely the two hawks Ian McCafferty and Martin Weale), considering ‘the outlook for inflation beyond the short term, there could well be a case for an increase in Bank Rate later in the year’. This is not surprising as they voted in favour of increasing the Bank Rate at several meetings last year. A new thing is that one member now judges that ‘the next change in the stance of monetary policy was roughly as likely to be a loosening as a tightening’. This is most likely due to the fact that inflation is much below the 2%-target.

The MPC expects CPI inflation to stay low until the end of 2015 due to temporary factors (especially the fall in oil prices) but states that ‘the effect of these factors on twelve-month CPI inflation would dissipate towards the end of 2015, causing inflation to pick up towards the target fairly sharply’.

UK swap rates trade a few basis points higher across the curve following today’s data release and the first full 25bp rate hike has been moved forward one month from April to March 2016 according to our central bank monitor. EUR/GBP trades around 0.5% lower (currently at 0.7385) which according to our short-term financial model is ‘fair’ given the increase in the 2Y UK interest rate.

Fundamentally, the UK economy is expected to continue to recover at a solid pace and we still look for the first hike to arrive in August– but stress that risks are tilted towards a hike later in Q3 or possibly in Q4. If we are correct, the BoE is priced much too dovishly and we see more upside potential in UK rates and look for a lower EUR/GBP in the coming three to six months as markets call for a re-pricing of MPC policy in a more hawkish direction.

However, we expect EUR/GBP to be fairly trendless and volatile in the months ahead of the general election on 7 May. We target EUR/GBP at 0.74 in 3M and 0.72 in 6M as downside potential may be counterbalanced by political risks in the coming months. On a 6 to 12 month horizon, we expect EUR/GBP to stabilise and eventually move higher as the eurozone recovers. We target the cross at 0.73 in 12M.