The writer is head of currency strategy at Rabobank
The UK’s weak growth outlook weighed on the pound throughout the year. This has meant that it has not benefited much from the Bank of England starting its rate hike cycle earlier than many of its G10 peers.
The pound has fallen about 10 percent against the dollar and just under 1 percent against the euro.
Economics textbooks indicate that higher interest rates are beneficial to currencies. That said, there has been clear evidence around the world recently that the tone of central bank policy statements has had a significant directional impact on foreign exchange markets, almost regardless of interest rate announcements. What matters is the commentary on the outlook.
And that tone from the UK was pretty bleak. In May, the pound plunged following the BoE’s announcement of the 0.25 percentage point rate hike, mainly as a result of the market shock from the central bank’s simultaneous downward revision to UK growth.
And in an astonishingly candid policy statement on Aug. 4, BoE Governor Andrew Bailey warned that the UK economy would plunge into a 15-month recession in the fourth quarter of this year. As a result, the pound fell lower against the euro, although it ended the day slightly higher.
This bleak outlook is accompanied by a warning from the BoE’s Monetary Policy Committee that it will continue to raise interest rates to contain inflation, which is now expected to peak at around 13 percent. At Rabobank, we expect an additional rate increase of 1 percentage point: 0.50 point 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 to boost demand once the supply-side problems driving inflation are resolved. Yet the current warnings about growth in the UK come at a time when investors are assessing Britain’s post-Brexit shape.
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 cut investment levels by nearly 25 percent in 2020-21, with the effects gradually piling up since the 2016 Brexit referendum.
In a speech last month, outgoing MPC member Michael Saunders stated that Brexit and Covid have reduced growth potential due to lower labor supply, weak investment and, specifically due to leaving the EU, reduced trade openness.
The fact that the pound has never been able to recover to the level it traded against the euro before the Brexit referendum is consistent with the weakness in investment over 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 does expose a currency to downward 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 not attractive to foreign savers. Investors want clear leadership dictated by fiscal prudence and policies designed to improve productivity and long-term growth potential.
Uncertainty is a powerful discouragement for many investors and it appears that the UK government has not done enough to convince foreign investors of the benefits of Brexit.
The two remaining Conservative Party leadership candidates worked closely with outgoing Prime Minister Boris Johnson and there are no guarantees that either would significantly change economic uncertainties and improve the general climate for investors.
The new prime minister could also struggle to gain widespread support in a country on the brink of recession. Labor shortages in the UK coupled with the spike in the cost of living have already led to strikes and with a winter energy price crisis looming further hot spots are possible. This could lead to a tumultuous period for politics in the run-up to 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 is also struggling with strong headwinds. As a result of the energy crisis, we expect a recession in the eurozone in the winter.
This means there is room for the pound to hold its own against the euro over this winter period, although we expect the pound to lose ground in 12 months unless the outlook for investors improves strongly. Against the port dollar, the weakness in the UK economic outlook implies the risk of a decline to $1.15 in the coming months from current levels of around $1.21, a level last held fleetingly at the start of the pandemic.