Fiscal headwinds are likely to weigh on UK growth

While the GBP has roughly kept pace with the USD this year and it is expected to outperform the EUR due to a significant growth differential, headwinds may finally begin to take a toll on cable over the coming year. UK economic growth remains relatively robust but the fiscal contraction of 3.4pp of GDP that is expected over the next three years would be a strong headwind in an environment of surprisingly low inflation. After reducing the fiscal deficit by about 0.8pp of GDP per year over the past five years, the government plans to accelerate the pace of consolidation through substantial cuts in welfare spending to reduce the fiscal deficit at a pace comparable to the most aggressive periods of UK fiscal tightening. 

"Against this backdrop, we have pushed back our expectations for BoE tightening from February to May 2016", says Barclays.

Although the UK is less vulnerable to the risks stemming from China's growth transition, trade linkages will likely further suppress already low inflation and perhaps dim confidence. The combination of low inflation, the consequent rise in real interest rates and GBP appreciation has led to a considerable tightening of UK financial conditions over the past year. MPC members have repeatedly expressed concerns about the disinflationary effects of the more than 20% REER appreciation since March 2013. While the currency has started to adjust lower recently, it remains about 7% overvalued. 

A recent speech by MPC member Kristin Forbes raised questions about the consistency and degree of exchange rate pass-through to tradable prices. It is not clear, however, that this view is held by the wider committee, and the market is likely to price further delays to BoE tightening if the currency does not continue to adjust lower.

"We expect still superior UK growth prospects to lead to continued sterling appreciation versus the euro, particularly as the ECB extends its asset purchase programme beyond September 2016 in the coming months. However, we expect GBPUSD to trend lower with EURUSD, as increasing risks are separating the GBP from the USD's more positive fundamentals", added Barclays.