Tuesday / June 18.
HomeMarketsPound’s rally does not bolster its foundations

Pound’s rally does not bolster its foundations

Theresa May’s first big speech on Brexit since she became prime minister removed some of the political uncertainty that has dogged the pound. However, the messiness of the politics of Britain’s exit from the EU still tops the lost of reasons why sterling will remain under pressure.

A list of the pound’s pros and cons quickly shows why it is languishing at levels last seen in the mid-1980s, when Reaganomics sent the dollar surging. Following the UK’s vote to leave, the pound’s performance has been characterised by a lack of buyers who believe the decline in the currency offers them a long-term opportunity.

Alongside the considerable risk of a protracted divorce between the UK and EU, weakening economic fundamentals — led by rising inflation and a hefty current account deficit — have the pound well on course for emulating its weak performance from more than three decades ago. As the accompanying chart, courtesy of BNY Mellon shows, over the past year the pound has been steadily tracking the 18-month downturn it carved between November 1983 and March 1985.

During the era of free floating currencies that followed the demise of the Bretton Woods system, the pound has not spent much time at its current levels versus the dollar, the euro or the yen. Sterling briefly fell below $1.40 in 2008 and 2001, having approached that threshold in the aftermath of its ejection from the European Exchange Rate Mechanism in 1992.

An era of sustained currency weakness suggests a lower standard of living as higher import prices and a rebound in dollar-denominated commodities fuels inflation, hitting UK consumers.

“We see a deterioration in political rhetoric around Brexit as a key catalyst for further sterling weakness” is how analysts at Deutsche Bank sum up the outlook for the pound. “The large terms of trade shock from full exit from the single market” could see sterling fall to $1.06 and close to parity with the euro.

By the middle of this year, or 18 months into the current downtrend for the pound, the contours of Brexit should be clearer. Any sense of a softer exit that helps the UK preserve trade and business relationships should help sterling find a floor. Indeed, the pound enjoyed a dramatic relief rally on Tuesday after Mrs May outlined her approach for leaving the EU, including presenting the final terms of a deal to a vote in both houses of parliament.

While that propelled the pound towards $1.24, a rise of nearly 3 per cent on the day, the prospect of a hard Brexit looms large. Also helping the pound was sentiment souring towards the US dollar after Donald Trump expressed his concern over a strong greenback. His plans to revive manufacturing jobs and US exports faces a headwind from dollar strength, another throwback to the Reagan era.

In sharp contrast to the era when ‘Purple Rain’ and Ghostbusters were hits, the current weak outlook for the pound does not simply reflect a strong dollar. The combination of Trumpflation and a hard Brexit are instead a one-two punch against the pound.

The promise of big tax cuts, infrastructure spending and regulatory reforms by Mr Trump all suggest a potent boost for US growth and inflation that will favour the dollar. A current comparison of each country’s real interest rates — government bond yields adjusted for core inflation — reveals a growing divergence. US 10-year real yields are near 0.30 per cent, while the UK measure has fallen below zero to about negative 0.3 per cent.

Whatever the official efforts to talk down the dollar in Washington and soothing speeches over Brexit negotiations in London, interest rate divergence firmly favours the dollar over the pound. That trend will only intensify as the incoming Trump administration succeeds in boosting the economy. Speaking at the World Economic Forum in Davos on Tuesday, Anthony Scaramucci, a Trump adviser, expressed concern over a strong dollar, but also argued a robust US and global economy could withstand such a development.

The pound’s jump against the dollar on Tuesday is a reminder the currency’s trend lower will not be a straight line. However, the best case for the pound is that a further decline is closer to a steady walk down, rather than taking an escalator sharply lower.

[email protected]

Source link