Pound still suffering from weak UK economic outlook

The writer is responsible for foreign exchange strategy at Rabobank

Weak growth prospects in the UK weighed on sterling throughout the year. That means it didn’t benefit much from the fact that the Bank of England started its rate hike cycle earlier than many of its G10 peers.

The pound fell about 10% against the dollar and just under 1% against the euro.

Economics textbooks indicate that higher interest rates are good 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 commentary on the outlook.

And that UK tone has been quite dark. In May, the pound fell following the announcement of a 0.25 percentage point rate hike by the BoE, mainly due to market shock following the simultaneous downward revision to British growth by the central bank.

And in a surprisingly candid political statement on August 4, BoE Governor Andrew Bailey warned that the UK economy was on the verge of sliding into a 15-month recession in the fourth quarter of this year. As a result, the pound fell against the euro, although it ended the day a little higher.

This gloomy outlook is accompanied by a warning from the BoE’s monetary policy committee that it will continue to raise rates in order to reduce inflation which is now expected to peak at around 13%. At Rabobank, we anticipate 1 percentage point of additional rate hikes: 0.50 point in September, 0.25 in November and 0.25 in December.

It is very likely that this tightening will reverse from the second half of 2023 to stimulate demand if the supply problems that fuel inflation are resolved. Nonetheless, the current UK growth warnings come at a time when investors are assessing the shape of Britain post-Brexit.

In a report published in June 2021, the BoE concluded that Covid and Brexit had a significant impact on business investment. He estimated that the UK’s decision to leave the EU has increased uncertainty and reduced the level of investment by almost 25% in 2020-21, the effects having gradually accumulated since the 2016 referendum on Brexit.

In a speech last month, outgoing MPC member Michael Saunders said Brexit and Covid had reduced growth potential due to falling labor supply, weak investment and, due to the exit from the EU in particular, the reduction in trade openness.

The fact that the pound was never able to regain the levels traded against the euro before the Brexit referendum corresponds to the weakness of investment over this period.

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The UK maintains a current account deficit with an imbalance of imports versus exports. It is not a pre-established indicator of currency weakness, but it does expose a currency to downward pressure under certain circumstances.

Given that the current account deficit indicates that the UK is a net borrower from the rest of the world, the pound should adjust lower if the country’s fundamentals are unattractive to foreign savers. Investors want clear leadership defined by fiscal prudence and policies designed to improve productivity and long-term growth potential.

Uncertainty is a powerful deterrent for many investors and it would appear that the UK government has not done enough to convince overseas investors of the benefits of Brexit.

The two remaining Tory leadership candidates have worked closely with incumbent Prime Minister Boris Johnson and there is no guarantee that either would significantly alter economic uncertainties and improve the overall environment for investors. .

The new prime minister could also struggle to garner broad support in a country on the brink of recession. Labor shortages in the UK, combined with the soaring cost of living, have already sparked strikes and, with a winter energy price crisis looming, new pockets of unrest are possible. This could lead to a turbulent time 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 is already priced in. The euro is also facing strong headwinds. Due to the energy crisis, we expect a Eurozone recession over the winter.

This implies that it is possible for the pound to hold up against the euro during this winter period, although we expect the pound to lose ground over the 12 months, unless the outlook for investors do not improve significantly. Against the safe-haven dollar, the weak UK economic outlook implies a risk of a slide towards $1.15 in the coming months from current levels of around $1.21, a level last held fleetingly at the start of the pandemic.

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