Sterling could recover from a pounding in markets

Sterling has dropped against most major developed currencies, but particularly the dollar. It now looks cheap on most measures, but is there a catalyst for it to change direction in the current febrile markets?

Its weakness partly reflects the global situation: sterling is a cyclical currency at a time when the global economy is weakening and investors are increasingly ‘risk off’. They prefer the relative safety of the dollar, particularly given the hawkish rhetoric from the Federal Reserve. The US central bank has made it clear that its priority is to tackle inflation and economic growth comes second. The Bank of England has been more tempered in its response. This has exerted downward pressure on sterling.

There are also domestic considerations. The UK has had significant political turmoil and the EU/UK relationship remains in flux. The potential rewriting of the Northern Ireland protocol risks the EU suspending parts of the Withdrawal Agreement, with difficult implications for the UK economy. This is happening at a time when the UK economy already looks weak relative to the rest of Europe.

Of these elements, a change in tone from the Fed would have the most significant impact for sterling. If the Fed looked set to slow its rate-rising fervour, it would improve the outlook for financial markets generally and particularly cyclical currencies such as sterling. Flows into the US currency are weak, leaving it particularly vulnerable to a Fed policy reversal.

Why might this happen?

The most obvious catalyst for a change in direction would be lower inflation data in the mid-July reading. It could also come from any weakening in jobs data, which has been persistently strong. Bad news for jobs could be good news for sterling.

Sterling has some improving fundamentals

The UK’s current account deficit has narrowed, fuelled by a higher surplus in services and a lower deficit in goods. To date, this has been ignored by the market, but could become more important if other factors subside.

At the same time, sterling is cheap

There have been significant inflows into the Gilt market. We also see UK investors repatriating foreign assets because sterling has fallen. Portfolio flows continue to move higher. Purchasing power parity indicators, such as the Economists’ famous ‘Big Mac’ index, also show sterling to be cheap versus other currencies.

There are still problems: the UK’s economy is weak and looks set to slow throughout the rest of the year. Leading indicators, such as house price data, suggest the domestic economy is already cooling and this will act as a brake on any sterling appreciation.

The UK’s relationship with the EU is also a problem. The best-case scenario is that the two sides find a compromise on this thorny issue, while the worst-case scenario is a fast, ‘no compromise’ approach from both sides that would see the EU move to suspend parts of the withdrawal agreement. This latter scenario is likely to weigh on sterling. There are shades of grey in between.

Over the long term, where sterling has deviated significantly from other currencies on purchasing power parity measures, it has signalled a likely appreciation for the currency over the next decade. As such, current readings suggest sterling should appreciate over the next 10 years. However, there are still plenty of headwinds that could prevent sterling reflecting improving fundamentals in the short term.