Policy uncertainty risks a rollercoaster run for the pound
Louis Ashworth considers sterling’s future as a top Wall Street bank says it is facing an existential crisis
The pound has been thrust into the limelight by fresh claims it has turned into a far less prestigious currency, raising questions over how that might further stoke inflation.
Sterling is one of the year’s worst currency performers, down 7.1pc against the dollar as of yesterday at roughly $1.26. Of all its global counterparts, only Sweden’s krona and Japan’s yen have had a worse run.
Its performance has prompted Bank of America to become the latest financial heavyweight to put Britain’s currency in its sights, claiming the pound faces an “existential crisis” and period of prolonged weakening.
“Sterling’s fall from grace has been epic given last year’s euphoria and in many ways has caught the investor community by surprise,” wrote Kamal Sharma, a foreign exchange analyst at the Wall Street giant. He argued the pound’s behaviour was in some ways more like the currency of an emerging market than one of the world’s richest nations. It has become a familiar refrain in recent years, with Britain’s reputation for steady fiscal performance giving way and sparking a rollercoaster run for the pound.
Sterling was battered to a 34-year low against the dollar at the onset of the pandemic, and spent much of late 2020 and early 2021 making a slow but steady comeback. Midway through last year, however, it appeared to peak, before entering a weakening phase that accelerated after Russia invaded Ukraine.
Some of the current weakness is a function of the flight to safe assets in recent weeks that has pumped up the dollar. Yet there are signs of deeper frictions and uncertainty in what the Bank of England might do next.
“Trying to trade the pound is becoming increasingly difficult,” says Sharma. “The politics and the policy mix of the UK still is not back to [how it was before the Brexit referendum] … there’s still a level of uncertainty and that means the pound continues to carry an idiosyncratic risk.”
The role of the Bank of England has come into increasing focus. The Monetary Policy Committee (MPC), led by Andrew Bailey, was quicker than major peers in raising rates last December, making it more lucrative to hold the pound because it would accumulate value more quickly.
Yet the Bank had already spooked markets with a false start a month earlier, choosing to hold rates when markets thought an increase was a certainty. “It all comes back to the episode through November and December where the market was really blindsided by the Bank of England,” Sharma says.
Now, the MPC is walking a tightrope on rates. Officials are balancing the prospect of slowing the economy by raising the cost of borrowing, while holding fire could potentially weaken the pound further and stoke inflation.
Meanwhile, the Bank’s first-mover advantage has been lost. Across the pond, the Federal Reserve is rushing ahead with interest rate increases. Closer to home, the European Central Bank’s chief economist Philip Lane has set out a “base scenario” of interest rate increases in July and September.
International investors are concerned that Britain’s growth worries and political headaches are also starting to weaken sterling. “We maintain our view that [the pound] remains a vulnerable currency,” Jane Foley at Rabobank said in a note yesterday.
The financial community is far from unified however. “It is a liquid reserve currency that is still a very integral part of the global trading system,” says Chris Turner at ING. “I’m not quickly writing off the pound, and I don’t get the perception that the pound is viewed as any less than it was.”
Derek Halpenny, at MUFG, says that sterling doesn’t show the volatility of an emerging market currency. Instead, he warns, the biggest issue is turgid business investment. The current cost of living crisis is likely to harm investment, which has slowed in the years following the vote to leave the European Union. “That’s a real fundamental issue that I think is certainly related to Brexit,” says Halpenny. “It’s hard to envisage those uncertainties being removed, over certainly a [medium term] horizon.”
Analysts at Société Générale say the pound is likely to weaken further in the short term, possibly below $1.20, as the cost of living crisis stings the UK economy, but to then rest over $1.30 over the coming half-decade.
Clearly, there is huge uncertainty among investors about where sterling goes next – or how far it might fall. But after six years marked by political strife, a pandemic, war and rampant inflation, traders will be well aware that events can quickly overtake even the most confident predictions.
‘Sterling’s fall from grace has been epic given last year’s euphoria and has caught investors by surprise’