GBP/USD

In the UK, real GDP expanded 0.6% qoq (1.5% yoy) in 3Q18, an acceleration from the 0.4% qoq growth in 2Q18 and 0.1% qoq in the first quarter of 2018. It’s the fastest rate of growth since fourth-quarter of 2016, but it’s very likely to prove temporary, as we explain below. We expect growth to ease to 0.3% qoq in fourth quarter of 2018, with the risks now skewed to the downside.

On the output side, growth in the third quarter of 2018 was broad-based. Services expanded 0.4% qoq (contributing 0.3pp. to GDP growth), industrial production rose 0.8% qoq (contributing 0.1pp. to GDP growth), and construction was up 2.1% qoq (contributing 0.1pp. to GDP growth). Here some temporary factors were clearly at work. The large rise in construction output in the third quarter of 2018 was likely due to catch-up from the very weak weather-hit first quarter of the year when output fell 1.6% qoq. The Bank of England’s regional agents confirmed this was a large factor behind the rise. The increase in industrial production was driven in part by volatility in the manufacturing sector, which expanded 0.6% qoq in the third quarter of 2018 after a fall of 0.7% qoq in the second quarter of 2018. And while the growth in services output slowed to 0.4% qoq in the third quarter of 2018 from the relatively strong 0.6% qoq growth in 2Q18, it was still buoyed by decent growth in the retail sector thanks to the warm weather and the World Cup effect, which also should prove temporary and will weigh on growth in the final quarter.

On the expenditure side, household consumption expanded 0.5% qoq (contributing 0.3pp. to GDP growth), government consumption was up 0.6% qoq (contributing 0.1pp. to GDP growth), gross fixed capital formation rose 0.8% qoq (contributing 0.1pp. to GDP growth), exports rose 2.7% qoq (contributing 0.8pp. to GDP growth) and imports were flat. Within gross fixed capital formation, the rise was driven by increases in government and private dwelling investment, largely offset by a sharp fall in business investment, down 1.2% qoq (-1.9% yoy), the third consecutive quarterly fall, which confirms the survey evidence that Brexit-related uncertainty is weighing more heavily on firms’ investment decisions.

Looking ahead, growth is likely to slow to 0.3% qoq in the fourth quarter of 2018, which would result in annual average GDP growth of 1.3% in 2018. The risks are skewed to the downside. In addition to the unwinding of the temporary factors that boosted growth in the third quarter of 2018, there is concern as to how households will react to Brexit-related uncertainty as the date when the UK leaves the EU (29 March 2019) draws nearer. So far households have largely looked through that uncertainty, in contrast to firms, but that could change. Meanwhile, firms will continue to delay their investment decisions until there is clarity on the Brexit transition, which we do not expect until the first quarter 2019. And net exports are likely to drag on growth in the fourth quarter of 2018, partly because of some payback from the strong third quarter of 2018, partly because global trade has slowed, partly because there's likely to be some stockpiling of imports ahead of a potential Brexit cliff-edge, and partly because the fillip for UK exports coming from the past depreciation of sterling has faded.

Next week, the Federal Reserve will end its seventh regular FOMC meeting of the year. It is widely expected that the committee will keep the target range for the federal funds rate at an unchanged 2.00% to 2.25%, while reiterating the outlook for another 25bp move in December. Newly appointed Vice Chair Richard Clarida said as recently as last Thursday, i.e. right before the start of the blackout period, that “even after our most recent policy decision to raise the range for the federal funds rate by 0.25 percentage point, monetary policy remains accommodative, and I believe some further gradual adjustment in the policy rate range will likely be appropriate.” Moreover, he added that “with the economy now operating at or close to mandate-consistent levels for inflation and unemployment, the risks that monetary policy must balance are now more symmetric and less skewed to the downside.” Neither the recent stock market volatility nor President Trump’s repeated comments have thus affected the Fed’s underlying policy view. This should be indicated by the statement reiterating its main policy outlook: “The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective over the medium term. Risks to the economic outlook appear roughly balanced.”

Rather than making any immediate policy changes, the Fed will likely use the meeting to discuss the size and composition its balance sheet should have after the normalization is completed. According to the minutes of the August 1 FOMC meeting, Fed Chair Jerome Powell suggested that such a discussion of operating frameworks would likely resume in the fall. Previously, the committee had said that it wanted the smallest balance sheet that is consistent with a good monetary policy. At some point, that general statement will need to be translated into a target size for excess reserves; we expect a ballpark range of USD 500 bn to USD 750 bn, compared to the current level of USD 1.7 tn and a maximum level of USD 2.7 tn, which was hit in 2014. With regard to the composition, the Fed has suggested before that it ultimately targets a Treasury-only balance sheet, which means that all MBS and agency debt holdings would be wound down. This is likely to be confirmed. A circumstance that is adding some urgency to the topic is the fact that the effective fed funds rate continues to push against the interest paid on excess reserves. Unless the situation changes by the December meeting, it seems likely that the Fed will once again raise the interest paid on excess reserves by less than the target range in order to push the effective fed funds rate back to the middle of the band.

U.S. nonfarm payrolls increased by 250k jobs in October as employment in the leisure and hospitality sector bounced back after being held down by Hurricane Florence, which drenched North and South Carolina in mid-September.

There were also big gains in construction, professional and business services payrolls, and manufacturing, where employment increased by the most in 10 months.

The economy created 118k jobs in September.

The Labor Department's closely watched monthly employment report on Friday also showed the unemployment rate was steady at a 49-year low of 3.7% as 711k people entered the labor force, in a sign of confidence in the jobs market.

The market had forecast payrolls would increase by 190k jobs in October and the unemployment rate would be unchanged at 3.7%.

Average hourly earnings rose five cents, or 0.2%, in October after advancing 0.3% in September. That boosted the annual increase in wages to 3.1%, the biggest gain since April 2009, from 2.8% in September.

Employers also increased hours for workers last month. The average workweek rose to 34.5 hours from 34.4 hours in September.

The Fed is not expected to raise rates at its policy meeting next week, but the market believes October's strong labor market data could see the U.S. central bank signal an increase in December. The Fed raised borrowing costs in September for the third time this year.

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