A tough spring in store for the pound

January 8, 2010

foley- Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The pound has started the year on a negative note.  Ongoing concerns over the budget deficit, an impending general election, the prospect that the Bank of England (BoE) may yet increase quantitative easing (QE) and a drop in consumer confidence are all clouding the outlook.

That said, sterling has already paid a high price for its weak fundamentals.  In 2009 EUR/GBP averaged 0.8909, this is 17 percent higher than its average in the 12 months leading to the Northern Rock crisis and 35 percent above the average rate between 2000-07.

A lot of bad news is in the price but a sustained sterling recovery is unlikely until there are concrete signs of resolution to the UK’s deficit problem.

In the midst of the deficit concerns, the government is still too uncertain about the prospects for economic growth to stiffen its commitment to austerity and, according to opinion polls, the opposition is not enjoying a decent enough lead to ensure it of election success.

This has left the pound worried by the possibility that this spring’s general election may produce a hung parliament and sensitive to the brutal suggestion from Pimco that if Labour return to power the UK may suffer a credit downgrade.

On a more positive note, the UK most likely emerged from recession in Q4.  This is hardly a cause for celebration, however, since most major economies emerged in Q2 or in Q3.

While the UK economic outlook may have improved the consumer remains wary.  The Nationwide this week reported that December consumer confidence dropped by the most in more than a year. Next and M&S are both cautious on the 2010 outlook. Higher VAT, low wage rises and the withdrawal of fiscal incentives have cumulated in a gloomy outlook.  On top of this some consumers fear rising interest rates.

A decision on whether to extend QE is expected from the BoE in February. The fact that growth in M4 remains lacklustre has been used to support the case for more QE.

It may be more pertinent to argue that the failure of M4 to see any significant boost from QE suggests that it is an inappropriate policy to support the real economy; though it was useful in pulling the financial sector away from the edge of the abyss.

If the BoE take this view, it could mean that rates will remain low for longer.   The weak pound has not yet provided a meaningful boost to exports and the withdrawal of fiscal stimulus means that low rates will be the key support to for the economy.

It is probable that there will be no hike in UK rates until Q3 and possibly beyond that.  Headline UK inflation is likely to rise to three percent y/y soon on the back of higher energy prices and the VAT rise.  Crucially, however, underlying inflation remains benign meaning inflation is a long way from causing rates to rise.

A decision to pause QE next month will provide a modest boost for sterling.  By year end, the likelihood that the UK labour market will be recovering faster than that of the Eurozone and an improving budget deficit should have pushed EUR/GBP well below the year’s highs.

The pre-election months could prove to be the most testing for sterling, though upside in EUR/GBP should be tempered by the EUR’s sensitivity to budget problems within the Eurozone.

Assuming that the USD maintains its improved tone, sterling’s weakness could be demonstrated more clearly in cable.   A break below the December low near GBP/USD1.5850 could trigger a move towards 1.5700, below could see a leg down towards 1.5500.

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