Political and fiscal risk to pose headwinds for sterling
Post-Scottish referendum, UK political risks have not gone away, while the fiscal picture remains dire.
The Scottish referendum rollercoaster achieved a rare feat for the sterling: FX traders momentarily fixated on an issue other than the monetary policy.
However, with the UK facing questions about its constitutional structure and weak tax receipts in August – imperilling the deficit-reduction programme – analysts say, at some point next year, fiscal policy and political risks could emerge as a headache for the sterling. The currency markets priced in the probability of a yes vote for Scottish independence at around 25%, says Nick Beecroft, senior market analyst at Saxo Bank.
“If there had never been a referendum, sterling would have been performing better against the euro, though it is harder to say how it would have fared against the dollar given its recent strength,” he says. “The result means it is back to business as usual for sterling.”
Recent weeks have given the markets a taster for what might be in store again soon, if the Conservatives win a majority in next year’s UK election and deliver the long-awaited referendum on EU membership.
HSBC believes the experience could inoculate the market against future political concerns.
“Now that the actual result suggests these polls [predicting a close election result] were a false alarm, it may be harder for future political events to get traction in the currency market,” states HSBC in a research note published post-result. “This suggests, for example, that next year’s UK general election should cause little disruption to GBP.”
Others are not so sure. “Politics is off the agenda for now, but it won’t be long before it’s back,” says Adam Cole, global head of FX strategy at RBC Capital Markets.
“The referendum result probably reduces the probability of the UK leaving the EU and that will probably be reflected by sterling as any referendum on that question approaches. But that isn’t the only political question.”
In the UK government’s determination to keep the Union together, it promised Scotland devo max, potentially giving its government the right to set income-tax rates and thresholds, and to establish its own welfare spending policy.
“In theory, transferring more responsibility for fiscal policy to Scotland could improve the UK’s public finance position, were it to lead to greater accountability and fiscal discipline,” states HSBC. “In practice, however, it could bring many of the problems associated with a monetary union.”
Specifically, HSBC believes the new arrangement could introduce moral hazard, with Scotland spending beyond its means in the knowledge that England would be there to bail it out.
“This could complicate the task of UK deficit reduction, which is planned to last until at least 2019,” states the bank.
None of this is of immediate concern to the currency markets, says Saxo’s Beecroft. “There could be some concern that the result strengthens [prime minister David] Cameron’s hand in a future EU referendum, and perhaps increases the chances the UK decides to leave the EU, but that is still a long way off,” he adds.
“Markets will not be thinking that far ahead – they only started thinking about the Scottish referendum in the last month or so.”
Of more concern to the markets, he says, will be the budget deficit, which remains huge by historical and international standards.
“The markets have been very tolerant of the deficit while there is a clear plan in place for dealing with it, but in a UK with a decentralized fiscal policy it will be much harder to maintain discipline, and that could be a big negative for sterling,” says RBC’s Cole.
At some point, the UK’s weak fiscal fundamentals will weigh on the sterling, expect analysts.
HSBC’s Daragh Maher adds: “It does not feel like either of the UK’s deficits have traction in a currency market more fixated on the outlook for monetary policy. So the failure of the fiscal balance to improve materially alongside rising economic activity has not been a big headache for sterling.
“However, were the current-account deficit to become a focus then so too might the fiscal shortfall.”
|UK current account compared with other G10 deficit currencies
|Source: RBC Capital Markets|
Says Cole: “Right now, market attention is on monetary policy, which is sterling positive, but that is going to gradually shift to fiscal policy which is negative. The question is when. I would guess this story will play out next year, but I say that with no real confidence.
“The August tax receipts certainly pushes us in the direction of worrying about fiscal policy sooner rather than later, but once the party conferences are over, I would think things will go a bit quieter again.”
Growth and rate-expectations remain a moving target. “In July last year, UK growth was forecast at around 1.5%, but economic data seemed to consistently surprise on the upside,” says HSBC’s Maher. “Now growth expectations have increased to around 3%, but now the surprises all seem to be on the downside. So expectations have probably overshot both times.”
The principal driver in the short term will be rate expectations, and there is a general consensus that the Bank of England will commence its rate-tightening sooner rather than later.
Beecroft says: “The Bank of England has its finger on the trigger for rate rises and will pull it some time either side of Christmas – I would say there is a 90% chance of the first rise having come by the end of Q1 2015.”
HSBC notes the strong relationship between UK and US interest-rate differentials and GBP/USD means any decline in UK rate expectations could result in a weaker pound.
So, for now at least, monetary policy will continue to drive the sterling.