Pound continues to suffer from weak UK economic outlook

Pound continues to suffer from weak UK economic outlook

Pound continues to suffer from weak UK economic outlook

The writer is head of foreign exchange strategy at Rabobank.

The weak outlook for UK growth has been weighing on the pound throughout the year. This has meant he hasn’t seen much of a benefit from the Bank of England starting its rate hike cycle earlier than many of his G10 peers.

The pound has fallen about 10 percent against the dollar and just under 1 percent against the euro.

Economics textbooks indicate that higher interest rates are favorable for currencies. That said, there has been clear evidence around the world recently that the tone of central bank policy statements has had a key directional influence on currency markets, almost independently of interest rate announcements. What matters is the comment on the perspective.

And that tone from the UK has been quite somber. In May, the pound tumbled following the BoE’s announcement of a 0.25 percentage point rate hike, mainly due to market shock from the central bank’s coincident downward revision to UK growth.

And in an astonishingly candid policy statement on August 4, BoE Governor Andrew Bailey warned that the UK economy would slip into a 15-month recession in the fourth quarter of this year. As a result, the pound stumbled lower against the euro, although it ended the day slightly higher.

This gloomy outlook is accompanied by a warning from the BoE’s Monetary Policy Committee that it will continue to raise rates to reduce inflation which is now expected to peak at around 13 percent. At Rabobank, we expect 1 percentage point of additional rate increases: 0.50 points in September, 0.25 in November and 0.25 in December.

There is a high probability that this adjustment will be reversed from the second half of 2023 to boost demand if the problems on the supply side that are driving up inflation are resolved. But still, the current warnings about UK growth come at a time when investors are assessing Britain’s post-Brexit shape.

In a report published in June 2021, the BoE concluded that both Covid and Brexit have had a major impact on business investment. It estimated that the UK’s decision to leave the EU increased uncertainty and reduced the level of investment by nearly 25 percent in 2020-21, with the effects gradually building up since the 2016 Brexit referendum.

In a speech last month, outgoing MPC member Michael Saunders claimed that Brexit and Covid have reduced growth potential due to lower labor supply, weak investment and, due specifically to leaving the EU, the reduced trade openness.

The fact that the pound has never been able to recover the levels it was trading against the euro before the Brexit referendum is consistent with the weakness of investment in this period.

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The UK runs a current account deficit with an imbalance between imports and exports. This is not a default indicator of currency weakness, but it does expose a currency to downward pressure in certain circumstances.

With the current account deficit signaling that the UK is a net borrower from the rest of the world, the pound is likely to adjust lower if the country’s fundamental backdrop is not attractive to foreign savers. Investors would like clear leadership defined by fiscal prudence and policies designed to improve productivity and long-term growth potential.

Uncertainty is a powerful disincentive for many investors and it appears that the UK government has not done enough to convince foreign investors of the benefits of Brexit.

The remaining two candidates for the Conservative Party leadership have worked closely with outgoing Prime Minister Boris Johnson, and there is no guarantee that either will significantly alter economic uncertainties and improve the overall environment for investors.

The new prime minister could also find it difficult to win wide support in a country that is on the verge of recession. Labor shortages in the UK, combined with the rising cost of living, have already led to strike action and, with a winter energy price crisis looming, more rioting is possible. This could lead to a choppy period for politics ahead of the 2024 general election, which would be another headwind for the pound.

Despite our negative outlook for the pound, a lot of bad news has already been priced in. The euro is also facing strong headwinds. Following the energy crisis, we expect a recession in the eurozone during the winter.

This implies that there is room for the pound to hold firm against the euro this winter period, although we expect the pound to lose ground on a 12-month perspective unless the outlook for investors improves considerably. Against the safe-haven dollar, the weakness of the UK economic outlook implies the risk of a fall towards $1.15 in the coming months from current levels of around $1.21, a level that was briefly held last time at the beginning of the pandemic.

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