Sterling Still Under Pressure, How Low Can It Go?

Image © Bank of England [2015] / Flickr

By James Harte

The unparalleled moves in Sterling over the last two weeks have drawn much investor attention with markets gripped by fear and greed equally. As the downside continues to play out, the big question on everyone’s mind is “how much further can it go?”

With markets continuing to the position in this new post-Brexit environment it is likely that we continue to see GBP under pressure give the current context of escalated political and economic uncertainty. However, with GBP down over 12% against USD, it is clear that many negatives are already priced in at this stage, such as a summer rate cut, and we could see some deceleration in Sterling’s free-fall.

The catalyst for Sterling’s renewed decline this week was a double blow of poor economic data (Construction PMI at seven-year lows in June & Service sector growth at 38 month lows in June) and the release of the BOE’s Financial Stability Report which saw the bank announce a reduction in the counter-cyclical buffer rates applied to domestic banks, from 0.5% previous to 0%, in an attempt to free up to £105bln for lending. The BOE referenced the decline in Sterling as a necessary function for economic adjustment and noted also that continued capital outflows would cause a further decline in Sterling.

Given the current decline, the BOE will be aiming to ease the correction in markets rather than aggressively targeting the support of asset prices. Triggering further FX depreciation would likely fuel further financial instability adding to the risk of stagflation. Thinking in these terms suggests that the BOE is likely to be more cautious

However, the biggest threat to Sterling at the moment is perhaps the correction to the UK’ s external imbalances. Continued portfolio outflows and earnings repatriation portend further FX underperformance. One important aspect to highlight is that the short-term financial liabilities segment of the UK’s Financial Account, which escalated the FX decline in 2008, is not so big a problem now as the majority of recent capital inflows have been portfolio flows and FDI typically with better “staying power”. This suggests less of a panic-stricken FX reaction going forward.

Looking At The ERM Crisis

The UK’s TWI has fallen heavily in the wake of Brexit reaching its lowest levels since 2013. In terms of trying to gauge how far GBP might continue to fall, it is useful to consider other periods of acute depreciation, notably the 1992 ERM crisis which saw GBP down around 30% against USD and JPY 6-months after the crisis hit. Within the first month after the 1992 episode, GBP was down just shy of 20% against the USD, which is comparable with the current reaction. Using this comparison there is scope for a similar decline over the coming 10 weeks.

BOE Outlook

Going into the Bank of England rates meeting next week investors are pricing a 75% chance of a 15bps cut with markets pricing a roughly 80% of zero interest rates before year end.  With markets already pricing in such moves, the main focus of this meeting will be on the banks language concerning the channel and scale of future easing. Within this context, there is clearly room for disappointment if the BOE fails to deliver the pre-emptive, forceful rhetoric that markets expect. If the BOE do pursue a more cautious tone next week, then we could see some profit taking, similar perhaps to the moves we saw in the EUR post-ECB December 2015 when markets were highly expectant of further easing/aggressive rhetoric yet ultimately unfulfilled by a disappointingly neutral ECB.

Quick Recap

Little new info from last night’s June FOMC Meeting Minutes. The June meeting took place just a week before the UK’s Brexit referendum and saw the Fed stressing a “wait and see” approach to the potential outcome whilst cautioning against the likely negative impact on the both the US and global economies. Given that Brexit has now occurred, much of the usefulness of these minutes has been lost besides an appropriate scaling back of investors’ US rate hike expectations. Incoming data over the next few months will be vital for both the Fed and markets in terms of gauging the impact on the US economy from Brexit while current inflation expectations have softened further as PCE remains below 2% and wage inflation remains subdued also

In terms of looking forward, the minutes noted that the Fed would need to ‘wait for additional data regarding labor market conditions as well as information that would allow them to assess the consequences of the U.K. vote for global financial conditions and the U.S. economic outlook’.   As such, a positive print is unlikely to add much in the way of support for the US Dollar, but a further negative print is likely to add significant downside pressure whilst darkening the already heavy clouds over the global economy.