UK: Sterling safe from currency war but Brexit casts a shadow

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Improved eurozone sentiment has seen sterling lose its safe-haven status and has renewed worries about the UK’s credit rating.

As Mervyn King, Bank of England governor, warns about currency wars, he can rest easy that sterling is not set to become a victim.

King recently expressed concern that we might now see "the growth of actively managed exchange rates as an alternative to the use of domestic monetary policy".

So far, however, sterling strength shows no sign of undermining the Bank of England’s attempts to revive the UK economy. Since the turn of the year, sterling is down 2.5% on a trade-weighted basis.

Indeed, the only two G10 currencies that have underperformed the pound are the yen and the Swiss franc, both of which are being actively weakened by policymakers seeking to use their currencies as a tool to invigorate their economies. In sterling’s case however, the market is doing the authorities’ work for them, pushing it below $1.60 to a two-month low against the dollar and sending it down to a 10-month trough against the euro.

Sterling has been assaulted from all sides, including through the drying up of haven demand for UK assets now that worries over the eurozone debt crisis appear to be receding.

Judging the outlook for sterling has been a relatively straightforward affair in recent times.

Market practitioners agree that in the past the importance of yield differentials in driving the performance of sterling would have been at the fore, but more recently the key issue has been investors seeking a safe haven away from the eurozone crisis.

But with the future existence of the eurozone now looking more assured, concerns are growing for the outlook of the pound.

Those worries include the prospect that the UK will lose its triple-A debt rating and the faltering health of the British economy – both subjects that have been overlooked by currency investors as the eurozone debt crisis rumbled on. And even as the eurozone debt crisis appears to ease, there are few signs of recovery in continental Europe, the UK’s main trading partner.

If renewed worries over the UK’s credit rating and economy were not enough, another factor also bodes ill for sterling: the prospect of the UK renegotiating part of its relations with the EU. Admittedly, change is a distant prospect – any alterations look set to be put before UK voters in a referendum after the next general election, provided of course that the Conservative Party-led coalition remains in government. For UK-based investors, the topic is well understood, but for international investors the UK’s relationship with its EU partners is less well known, and only now, it seems, attracting their attention.

What is clear is that the pound is suffering, and with interest rates at ultra-low levels and unlikely to rise in the near future, it could well transform into a funding currency for carry trades. That would be quite a switch for a currency that just a few months ago was benefiting from haven demand. One thing seems still more certain: for now the Bank of England should have no need to engage in currency wars.