Key UK data and the government’s Brexit position
While markets are in the midst of summer holiday mode, the combination of key UK data releases, as well Brexit and geopolitical headlines, may present some near-term turbulence for GBP markets. On the data front, there are three key reports to note next week:

CPI report (Tue 15th Aug): After coming in surprisingly softer last month – and denting August Bank of England rate hike expectations – our economists expect annual headline inflation to pick up to 2.7% as GBP weakness continues to feed through into higher food prices. Utility price hikes are also beginning to take effect. Equally, core inflation could rebound to as high as 2.6%. While this is likely to raise some eyebrows among the MPC hawks, we would caution that part of this increase is also due to the transitory effects of a weaker currency. Given that domestically generated inflation overall is likely to remain muted for some time, we suspect any subsequent move higher in short-term UK rates and GBP – as a result of greater BoE tightening sentiment – may prove short-lived.

Labour market report (Wed 16th Aug): Those looking to wage growth as evidence for rising underlying price pressures are unlikely to find much support in the latest jobs report. We expect average hourly earnings growth to remain unchanged at 2% in June – and stay pretty much anchored at this level for the rest of 2017. This may not come as too much of a surprise to markets given that it would be in line with the BoE’s latest forecasts outlined in the August Inflation Report. The bigger question, however, is whether wage inflation can pick up to 3% in 2018 as the Bank estimates; such a sharp uplift in earnings growth is unlikely in our eyes given greater signs of slack in the labour market.

Retail sales report (Thu 17th Aug): Our view for a more cautious BoE policy bias would be reinforced by a disappointing July retail sales report. While the second warmest June on record got UK consumers out spending at the start of summer, a range of factors, including waning confidence and less credit-card spending, suggest households are cutting back on non-essentials as the squeeze on real incomes takes effect.

Reports in the media also suggest the UK government is set to release position papers on key Brexit issues in the next few weeks. Of particular economic interest will be the UK’s proposals for replacing the customs union and achieving ‘frictionless trade’ with the EU. We could also receive clarity on the type of transitional deal the UK is willing to seek, notably the length of any transition period and willingness to replicate existing arrangements.

GBP implications: Data to deliver final blow to 2017 BoE rate hike calls
We expect the next round of key UK data releases to be the final nail in the coffin for a 2017 BoE rate hike. The implied probability of a 25bp hike by year-end has already fallen to less than 25% after the BoE’s dovish disappointment. While higher inflation figures may keep lingering hopes alive, the slowing trend in consumer activity, as well as uncertainty over the degree of slack in the labour market, should keep the hawks at bay. Risks are that the front-end of the UK curve continues to flatten and that BoE rate hike expectations get pushed further out into 2018. This could weigh on GBP in the near-term.

On the Brexit front, we continue to believe it is too early for GBP markets to price in any Brexit transitional deal hopes; there are a number of “divorce” stumbling blocks that need to be overcome before any transitional arrangement is signed, sealed and delivered. Diminishing tail risks of a cliff-edge Brexit is certainly easing any major downside GBP pressure but the currency is far from out of the woods when it comes to political event risks. We earmark early October as a key test for GBP markets; both the governing Conservative Party Conference (1-4 Oct) and the final round of opening Brexit talks (Oct 9) will shed light on the stability of the UK political environment, as well as any progress being made when it comes to the UK’s ‘smooth’ exit from the EU.

UK consumer price inflation is getting closer to 3%, but slower growth and political uncertainty mean there is little chance of an interest rate rise. The pound’s collapse since last June’s EU referendum has seen import prices rise across the board, but it has been most felt in food and fuel costs. This has seen headline CPI rise to 2.7% YoY and we look for it to push higher again today. This is primarily due to higher utility bills (gas and electricity) with providers having announced significant price hikes in response to wholesale price moves. There are also tens of thousands of households impacted by fixed term deals coming to an end this month. These people will find themselves put automatically on higher price tariffs.

However, there is going to be some offset from a temporary drop in motor fuel prices (they have risen again in early June), but with an increasing number of retailers facing higher import costs as their currency hedges come to an end we suspect headline inflation will rise to 2.8% before hitting 3% in 4Q17. Tomorrow’s labour report is likely to show wages remain little changed so the squeeze on spending power looks set to intensify. Already, there are worrying signs for consumer spending with this week’s retail sales report likely to post a heavy decline after a bizarrely strong outcome last month. Indeed, Visa, the payment card provider, reported that according to its own internal data consumer spending is now falling when adjusted for inflation. The pain is likely to get worse before it gets better.

The outcome of the election is not helpful for the growth story either. The uncertainty that this generates is prompting a steep fall in business confidence. The Institute of Directors found that 57% of their members were either “quite” or “very” pessimistic about the UK economy over the coming year versus just 20% who described themselves as optimistic. Given the lack of positive news flow on the domestic economy and the political uncertainty the UK faces it is not surprising that financial markets are pricing in a less than 10% chance on an interest rate rise this year, with the probability of a rate rise by the end of 2018 put at just 33%. Given the lack of domestic price pressures (as highlighted by subdued wage growth) we don’t expect an interest rate hike before the official deadline for Brexit talks to conclude in 2019.

The failure to secure political stability – and the outcome of a hung parliament – was always going to be the pound’s nightmare scenario. When Theresa May called this election, markets were viewing things through the rosiest of lenses – with hopes that political uncertainty would decrease substantially under a more stable Conservative government. That narrative has been all but dashed. With the two-year Article 50 clock ticking, the passage of time is GBP negative; a working government is needed as soon as possible to avoid a further drop in the pound. The most likely path looks to be a Conservative-led coalition with the Democratic Unionist Party (DUP); while it may not be straightforward given noise over Theresa May possibly standing down, GBP could enjoy a small relief rally on any political clarity. The worst outcome for GBP now is any prolonged political uncertainty and difficulties in forming a working government over the coming days; here we would expect GBP to trade with a 3-4% political risk premium, with GBP/USD falling back to 1.24 and EUR/GBP moving up towards 0.90.

The FT reports that Labour and Conservative party strategists predict a comfortable 50-100 seats majority for the Tories. If confirmed, markets may see an initial relief rally. Nonetheless, over recent weeks, GBP has turned from a ‘buy the dip’ into a ‘sell the rally’ currency. We cite a handful of reasons.First,valuation is no longer as much in favour of sterling as compared to November when we expressed our out-of-consensus bullish GBP call. Second, GBP weakness has failed to provide a positive contribution to net exports. Third, EMU’s negotiation stance has hardened. Instead of considering making concessions to the UK, the EU has started focusing on deeper political and economic integration.Fourth, PM May has been criticised of weakness during what the FT has suggested has been “widely seen as a misfiring campaign’after the apparent reversal of part of the social care policy.Finally, the UK’s national balance sheethas weakened over recent months as households reduced savings, bringing forward consumption, while the real estate sector has started slowing as indicated by today’s release of the May RICS house price index slowing from 22% to 17%.