Traders in London.
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LONDON — The British pound is on firmer footing for the reason that appointment of latest Prime Minister Rishi Sunak, but Wall Street still sees further vulnerability over the following 12 months.
After falling to a record low against the dollar of below $1.04 on Sep. 25 following the disastrous fiscal policy announcements that might eventually result in the resignation of former Prime Minister Liz Truss, sterling had recovered to around $1.139 by Thursday morning, but stays down over 15% year-to-date.
Sunak’s planned return to a more traditionally conservative fiscal policy agenda mostly stabilized markets and reduced expectations for more aggressive rate of interest hikes from the Bank of England, offering respite to the currency.
In a note Monday, Deutsche Bank vp and FX strategist Shreyas Gopal said the “crisis” chapter on the U.K. can now close, with the pound now more likely to trade as a “normal” currency, but noted that downward pressure from large external financing needs and low real rates stays.
“The U.K.’s external financing needs remain large and, on current market pricing, real yields are still too low in comparison with other major currencies. So long as the worldwide risk environment stays weak this leaves the pound vulnerable and the likely trend lower,” Gopal said.
The Bank of England is anticipated to lift rates of interest by 75 basis points on Thursday, its biggest hike since 1989, but economists expect the central bank to adopt a more dovish tone and ultimately fall in need of the terminal rate of just about 5% priced in by the market.
“In all, we remain bearish on the pound and imagine GBP weakness will return for the remaining of the 12 months,” Gopal said.
“Within the volatility space, the market has rightly assessed that the tails have narrowed for the pound, consistent with our view, and we take profit on our short volatility recommendations from earlier this month.”
The U.K.’s long-running current account deficit has been exacerbated by soaring energy prices, which have added almost 2% of gross domestic product to the country’s trade deficit over the past 12 months while placing a historic squeeze on household incomes. U.K. real wages fell at a record rate within the second quarter and inflation hit a 40-year high of 10.1% in September.
Gopal suggested that because of this, private sector savings may fall further in the approaching quarters with a view to sustain consumption of essential goods, while the federal government’s latest fiscal plans, set to be specified by full later this month, will likely mean public sector borrowing will exert less downward pressure on the trade balance.
The federal government has also promised further details on a more targeted version of the Energy Price Guarantee scheme, which is able to reduce government spending but will further cement the U.K.’s likely recession.
“This could result in import compression and a (cyclical) improvement in the present account balance — though as a fraction of GDP this impact is more likely to be less pronounced,” Gopal said.
“Beyond this, two other offsets include the recent fall in gas prices, with the farther from their peak that gas prices settle the higher for the external accounts.”
While the recent news flow has been more positive for the U.K. current account, Deutsche Bank doesn’t imagine it can prevent external deficits growing “wider than usual and wider than other developed market peers.”
A dovish shift in monetary policy can be seen as negative for the pound given how much tightening is priced in. What’s more, the removal of fiscal support during a very tough economic downturn could also be “easier said than done,” based on Goldman Sachs.
“Taking these items together, we’re revising our Sterling forecasts in a more positive direction, but still expect some further GBP underperformance ahead,” Kamakshya Trivedi, head of world FX, rates and EM strategy at Goldman, said in a note last week.
Goldman last week upgraded its three-, six- and 12-month outlooks for the pound to $1.10, $1.11 and $1.22 from a previous projection of $1.05, $1.08 and $1.19.
Not the last crisis for the UK
Despite the persistent vulnerabilities, nonetheless, analysts don’t see a return to the record lows seen in late September. In a note Tuesday, BMO Capital Markets suggested that a less hawkish posture from the Bank of England was unlikely to trigger an aggressive near-term sell-off of the pound, nor would a more restrictive stance create buying pressure.
“The U.K. economy and the GBP still have quite a few macroeconomic and balance of payments (BoP) headwinds to face. Nevertheless, one in all the more appealing features of the U.K. macro picture is that it’s generally useful to be the primary to have had a crisis and emerge from it on the opposite side,” said Stephen Gallo, European head of FX strategy at BMO.
On a longer-term horizon, nonetheless, Gallo said the Canadian investment bank was skeptical that 2022 could have marked the last crisis for the U.K., whether across the currency, balance of payments or fiscal policy.
“We might argue that overall UK risk premia ought to be higher today than in the course of the prior 10-year period. Nevertheless, probably the most aggressive phase of the re-pricing appears to be fading in the space of the rearview mirror,” he added.
