The author is head of currency strategy at Rabobank
The UK’s weak growth outlook has weighed on the pound all year. This has meant that it has not seen much benefit from the Bank of England starting its rate hike cycle earlier than many of its G10 peers.
The pound has fallen around 10 percent against the dollar and just under 1 percent against the euro.
Economics textbooks indicate that higher interest rates are supportive of currencies. That said, there has recently been clear evidence around the world 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 tone from Britain has been pretty grim. In May, the pound fell following the BoE’s announcement of a 0.25 percentage point interest rate hike, primarily due to the market’s shock over the central bank’s coinciding downgrade for UK growth.
And in a stunningly frank policy statement on August 4, BoE Governor Andrew Bailey warned that the UK economy was set to fall into a 15-month recession in the fourth quarter of this year. The pound fell against the euro as a result, 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 interest rates to curb inflation which is now expected to peak at around 13 percent. At Rabobank, we expect 1 percentage point additional interest rate increases: 0.50 points in September, 0.25 in November and 0.25 in December.
It is highly likely that this tightening will be reversed from the second half of 2023 onwards to boost demand if supply-side issues lifting inflation are resolved. But even so, current warnings about UK growth come at a time when investors are assessing the shape of Britain after Brexit.
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 investment levels by almost 25 per cent in 2020-21, with the effects building gradually since the Brexit vote in 2016.
In a speech last month, outgoing MPC member Michael Saunders stated that Brexit and Covid have reduced growth potential through lower labor supply, weak investment and, due specifically to leaving the EU, through reduced trade openness.
That the pound has never been able to recover to the levels traded against the euro before the Brexit vote corresponds to the weakness of investment during this period.
The UK maintains a current account deficit with an imbalance between imports and exports. This is not a predetermined indicator of currency weakness, but it exposes a currency to downside pressure under certain circumstances.
As the current account deficit indicates 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 unattractive to foreign savers. Investors want clear leadership defined by fiscal prudence and by 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.
Both of the remaining candidates for the Conservative Party leadership worked closely with outgoing Prime Minister Boris Johnson, and there are no guarantees that either will significantly change economic uncertainty and improve the overall environment for investors.
The new prime minister may also struggle to gain broad support in a country on the brink of recession. Labor shortages in the UK, combined with rising living costs, have already created strike action, and with a winter price crisis, further unrest 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 also faces strong headwinds. Against the background of the energy crisis, we expect a recession in the eurozone during the winter.
This means there is room for the pound to hold against the euro this winter, although we expect sterling to lose ground over a 12-month horizon unless the outlook for investors improves significantly. Against the safe-haven dollar, the weaknesses in the UK economic outlook risk a fall towards $1.15 in the coming months from current levels of around $1.21, a level last held volatile at the start of the pandemic.