Alongside the country’s political chaos, the UK’s economy is under enormous pressure – something that is clearly reflected in the fortunes of its currency. Research published by HSBC in July noted that sterling slipped 3.4% against the dollar in June, with the positive reaction to the Bank of England’s promise to act forcefully on inflation if needed fading towards the end of the month.
HSBC suggests the BoE will struggle to deliver as aggressive a hiking cycle as the US Federal Reserve, which should see sterling face ongoing downward pressure.
While the BoE has indicated that it is open to a faster pace of tightening, its monetary policy committee (MPC) has tended to place a lot of weight on the outlook for growth, even if inflation has had greater sway more recently.
“With activity data slowing and rising risks of a disruption to gas supply, should the BoE hike by less than is priced in this year – as we expect – this is likely to weigh on the GBP,” says Parisha Saimbi, G10 FX strategist at BNP Paribas Markets 360, which expects the central bank to hike by 50 basis in August (as is well priced) before reverting back to 25bp increments, up to a terminal rate of 2.5% by December.
In contrast, markets price 170bp hikes by December and a terminal rate above 3% reached in the first quarter of 2023.
“With growing fears of a global recession, the GBP could also be hit if cross-border portfolio flows slow given the UK’s reliance on foreign funding of its large current account deficit,” adds Saimbi. “We expect EUR/GBP to climb to 0.88 this year.”
EUR/GBP is 0.84 on Friday.
Hostage to the Fed
The economy looks very fragile and is likely to fall into recession as the cost-of-living crisis bites, says Craig Erlam, senior market analyst at Oanda. “Faster rate hikes will only compound the pain, but the central bank must get inflation under control.”
The debate may rage over 25bp or 50bp increases, but neither makes the pound more or less appealing. Currencies including sterling are currently hostage to what the Fed does with interest rates and the performance of risk assets.
That is the view of Kenneth Broux, head of corporate research, FX and rates at Societe Generale, who acknowledges that raising UK rates by 50bp right now is viewed as counterproductive because it adds downside risks to already weak economic growth.
“There are not many winners in FX against the dollar because everyone is in the same boat fighting the same inflation war,” he says. “The debate will move on when there is greater certainty that price pressures are receding around the world. The pound could strengthen once the Fed takes its foot off the monetary brakes, but that moment is still some time away. In the meantime, we must hope that the UK economy does not worsen.”
Charlotte Hampshire-Waugh, global head of trading payments at StoneX Financial, says the market is bearish almost everything apart from the greenback at the moment, so any reversal of this generic trend for GBP will only come if data points relating to unemployment, retail sales, GDP, purchasing managers indexes and earnings print mostly positive.
BNY Mellon’s models suggest that GBP/USD is roughly 5% to 8% undervalued, putting fair value around £1/$1.27 and adding to inflationary pressures in the UK. The rate on Friday is £1/$1.216.
“While the central bank might prefer to take a more dovish stance given cost of living pressures on UK households, inflation overshooting expectations could motivate the MPC to hike more aggressively,” suggests Daniel Tenengauzer, head of markets strategy at BNY Mellon.
“BNYM iFlow data shows that the market is long the pound, but has been very gradually reducing longs since last November,” he adds. “Rate hikes together with undervalued pound have been supporting investor buying of gilts for the past three months.”
Shreyas Gopal, strategist at Deutsche Bank Research, says the BoE governor’s comments about raising rates more aggressively have had little impact for two main reasons.
“Firstly, the market has been pricing a strong chance of the BoE moving up to 50bp rate hikes for a while now,” he explains. “Secondly, monetary policy has generally taken a backseat in recent weeks, with external factors such as global equities and rising gas prices dominating. These have broadly weighed on sterling, especially against the dollar.”
The only real indications of positivity for the pound come from Manpreet Gill, head of fixed income, currencies and commodities investment strategy at Standard Chartered Wealth Management, who expects GBP/USD to return to 1.27 in the longer term as progress is made on challenges relating to inflation, weak growth, unresolved Brexit-related issues and (most importantly) the dollar starting to turn lower.
Political elephants
The elephant in the room is the current Conservative Party leadership contest, which is set to run until early September. A JPMorgan research note dated July 22 says that GBP trading weak relative to fair value may be exacerbated by political developments closer to September.
The report states that “diverging policies between the two candidates means that the evolution of the campaign process could eventually become material for GBP as we draw closer to the actual election, but our bearish view is predicated on the still exceptionally high inflation and deteriorating external accounts”.
Standard Chartered takes the view that a clean transition to new political leadership would reduce political uncertainty for the currency, though this may come after GBP/USD drops as low as 1.176.
However, the HSBC report notes that GBP has not reacted much to political developments as yet and suggests that a meaningful change in trend is only likely if there is a big shift in one of two key policy areas.
“The change in leadership has not had a material impact on the pound as yet, given it comes at a time when the broader macro backdrop is so uncertain,” says Gopal. “We do not see a high likelihood of a general election until 2024, since the Conservatives are trailing by around 10 points in the polls but retain the ability to pass legislation in parliament given their healthy majority.”
A potentially looser fiscal policy that offers upside potential to growth and helps to alleviate the real-income squeeze facing UK consumers might help GBP, particularly if it was met by a more hawkish BoE.
On Brexit, any signs of a more collaborative approach with the EU might also support GBP.
Tenengauzer notes that the ongoing political uncertainty – combined with tighter fiscal stance – has had a negative impact on investor sentiment towards UK equities with investors selling the FTSE since January.
“Were Liz Truss to become Tory party leader and general elections follow, the pound would be more volatile given her bid to make a clean break from the recent policy mix,” he adds. “But this is something to worry about after September 5.”
The market isn’t concerned about political uncertainty in the raw sense, according to Hampshire-Waugh, “it is concerned about the actions the new leadership will take on the addressable issues that the UK is grappling with.”
