Fundamental Forecast for British Pound: Neutral

- U.K. GDP Revised Higher To 0.3% From 0.2%
- Mortgages Rose to 37,00 from 35,729 in April According to BBA
- Retail Sales Fall to 14 Month Low According to CBI

The British Pound would mark gains against most currencies during the past week despite ending flat against the dollar as concerns that the European debt crisis would make its way to the U.K.’s doorstep eased. However, a Fitch downgrade of Spain’s sovereign rating to “AA+” from “AAA” reminded markets that the Euro-area is far from circumventing the problem weighing on the Cable despite pre-holiday volume. Sterling booked most of its weekly gains on the back of a surge in risk appetite following comments from China that the Asian giant was remaining a long-term investor in Europe. The remarks and the implementation of measures to bring budgets under control have helped stabilize yields. Improving U.K. fundamentals also helped generate sterling support as the second reading of first quarter GDP was revised higher to 0.3% from 0.2%, and home loans rose to 37,000 from 35,0444. However, a 14 month low in retail sales underlines the country’s dependence on demand from abroad to generate growth especially with large cuts in government spending expected from the new government.

The coalition of the Conservatives and Liberal democrats set out this week to start measures that would slash public spending by 6 billion pounds from a budget deficit that has reached above 150 billion approximately 11% of GDP. However, there are already signs that the honeymoon is ending for the adjoining parties as there are rumblings over a proposed capital gains tax. If markets lose confidence that the government can push through the necessary legislation to rein in the deficit, then we could see additional sterling weakness. In his first major speech since taking office two weeks ago, on Friday David Cameron named cutting the budget deficit as one of the top priorities for the new administration as it will help restrain inflationary pressures and allow for interest rates to remain lower for an extended period.

The Prime Minister also stated that "We have seen a slightly worrying increase in inflation in recent months, so interest rates will be set to control inflation." The comments were viewed as a hint to the BoE to look to prevent further appreciation of prices. Indeed, the Organization for Economic Cooperation and Development recommended that the central bank hike rates sharply to prevent a rise in inflation and the damaging effect that it brings. Talk of future tightening could become a supporting factor if it leads to a rise in interest rate expectations. However, Governor King has dismissed the recent rise in consumer prices to 3.7% as policy makers continue to forecast that existing slack in the economy will bring rates back to their 2.0% target.

The economic docket will bring event risk in the form of the PMI manufacturing report as the sector has been the main driver of growth. Forecasts are for a slowdown in activity which could raise growth concerns and dim the prospect of a rate hike. Conversely, the service sector reading is expected to show improvement which could raise the hope that domestic growth is strengthening. The pound continues to see its correlation with equities increase as the BoE is expected to remain on hold, so its fate will most likely be tied to risk trends on the week.

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