Risks starting to build up for sterling as growth continues to slow

British Pound coin on a chart with a line graph.

Growth in the UK economy slowed last year, with GDP increasing by an estimated 2.2%, down from 2.9% in 2014. Meanwhile, inflation was much weaker than expected. The CPI rate in the UK has been stuck at between -0.1% and +0.1% since last February writes Oliver ManganChief Economist atAIB.

Largely as a result of these developments, the rate hikes expected in the UK last year never materialised. The Bank of England’s most recent commentaries suggest that it may keep UK rates on hold for the whole of this year also. This softening of UK rate hike expectations put an end to the strong appreciation by sterling evident in 2014 and first half of 2015. Indeed, sterling was confined to a 70p-75p range against the euro for most of 2015 and lost a considerable amount of ground against the burgeoning dollar in the second half of the year.

It is hard to argue for a renewed strengthening of sterling. The currency has already risen quite sharply on a trade-weighted basis since mid-2013. The UK, though, has a large balance of payments deficit suggesting that sterling may be overvalued. Meanwhile, the UK economy is slowing. There are a number of headwinds to growth, including high household debt, fiscal tightening, and the negative drag on trade from a strong sterling, as well as the slowdown in emerging economies.

Overall, UK GDP growth could average less than 2% in 2016. Furthermore, inflationary pressure remains very subdued. With oil prices still in sharp decline and pressure on domestic costs easing, most notably through a marked deceleration in wage growth over the second half of last year, it may be some time before inflation rises back up to its 2% target level. Indeed, up until recently, the view of the Bank of England was that the balance of risk was that CPI inflation would pick up to slightly exceed its 2% target in two years’ time.

Following its policy meeting last week, the BoE now judges that the risks to this projection lay a little to the downside. Not surprisingly, then, markets are increasingly of the view that UK rate hikes are quite some time away. Futures contracts suggest that the markets do not expect rates to increase until the first half of 2017. It could be mid-2018 before rates rise to 1% from their current level of 0.5%. Meantime, the referendum on the UK’s continued membership of the EU, or ‘Brexit’, represents a serious event risk for sterling. The referendum seems likely to be held around mid-summer or early autumn.

The EU heads of state summit meeting in mid-February, which will consider the UK demands for reforms to the EU, is the next big Brexit event on the calendar. A growing risk of Brexit would introduce a considerable amount of uncertainty in financial markets. Indeed, sterling finished 2015 on a soft note as opinion polls began to point to a very close result in the referendum vote. This weakening trend has continued into early 2016. The past week has seen sterling fall below $1.45 against the dollar for the first time since 2010. Meanwhile, the euro also moved above the 75p level for the first time in nearly a year. Thus, two important technical support levels for sterling have given way recently.

This weakening trend to sterling could continue, given the downside risks for the currency we have highlighted above — large balance of payments deficit, slowing growth, continuing low interest rates, and Brexit. However, we would expect the 2009 lows against the dollar at around $1.39-1.40 to provide strong support for sterling as the UK currency has not fallen below this level since 1985.

Meanwhile, the euro could rise to 78p in the coming months ahead of the Brexit referendum, especially if the opinion polls continue to point to a close result. Sterling should recover some lost ground, though, if as is generally expected, the UK votes to stay in the EU. However, a vote to leave the EU would herald a prolonged period of major uncertainty, weighing on UK economic growth. This could well lead to a sharp fall by sterling. Thus, Brexit will be a key factor in sterling moves this year.

Source: Irish Examiner January 19th 2016