Are British Pound ETFs Signaling Trouble Ahead?

Sweta Killa: The British currency has been on a roll this year and touched the highest level against the U.S. dollar in almost six years early this week. Most of the upside was driven by improving economic fundamentals and the prospect of interest rate hikes sooner than expected.

In fact, the two British currency Exchange Traded Products –CurrencyShares British Pound Sterling Trust (NYSEARCA:FXB) and iPath GBP/USD Exchange Rate ETN (NYSEARCA:GBB) – have been the best performers in the currency ETF space over the trailing one-year period. FXB is up 12.7% while GBB has gained slightly more at 14.7% for the same period. However, this trend might not continue long given mixed economic indicators and some technical weakness.

Bright Spots

The U.K. economy is growing faster than most of the developed economies and the Euro zone nations. This has been confirmed by the latest manufacturing data from Markit, which shows that June activity picked up at its fastest pace in six months, making the second quarter one of the best over the past two decades for manufacturers.

The recent consumer survey by the global market researcher GfK also points to the highest consumer confidence level in more than nine years in June, boosting the growth outlook for the country.

Inflation has risen to 1.9% in June from 1.5% in May but is still below the central bank’s target of 2%. Unemployment is declining, with the rate dropping to the lowest level in six years to 6.5% in May.

Improving consumer confidence, rising inflation and falling unemployment have heightened the speculation that Bank of England (BOE) could be the first major bank to tighten the stimulus and increase interest rates from a record low of 0.5%. If this happens, it would further support the currency upswing (read: Can Rate Hikes Save these Emerging Market ETFs?).

Threats

While the manufacturing sector is booming, productivity remains bleak. This is especially true as industrial production unexpectedly fell 0.7% in May compared to the revised 0.3% growth in April. This represents the second drop in the last five months.

Strength in the pound is making goods expensive for customers in other countries, thereby impacting exports. As such, the country’s trade deficit widened to £2.4 billion in May from £2.1 billion in April. This indicates that trade deficit remains a major drag on economic growth.

Further, though an improving job market is definitely bolstering the bull case for the sterling, pay raises are still pitiful. According to the latest indicators from the Office for National Statistics, average weekly wage growth including bonus has declined from 1.9% (January–March) to 0.3% (March–May), the lowest since 2009. In addition, average weekly wage growth excluding bonuses also reached its lowest level in more than a decade with an increase of 0.7% year over year for the same period.