Much like the UK economy, pound sterling suffers from a certainty deficit
Barrelling around in the piping of the UK economy so far this year has been a sustained pound sterling rally.
Britain’s currency in 2023 has been one of the best performers in the rich world. It is up nearly five per cent against the US dollar at $1.26, a far cry from the record low it kissed against the greenback in the days after Liz Truss’s haphazard mini-budget. Also a world away for people who remember getting $2 for every £1.
Against the euro, sterling’s gained about 2.6 per cent.
Good news for holidaymakers. Good news for households. Good news for investors and good news for a government trying to halve inflation by the end of the year.
There’s some simple economics underlying the pound’s rise.
Britain is suffering from the worst inflation problem in the rich world. It remained unchanged at 8.7 per cent in May. Core inflation rose above seven per cent. Services prices are rising at a similar pace.
As a result, financial markets now think Bank Governor Andrew Bailey will outdo his peers at the Federal Reserve and European Central Bank. Markets think US rates will peak around 5.75 per cent and four per cent in Europe.
Investors are faced with a suite of decisions every day on where to park their cash. Their only goal is to make as much money as possible.
With UK rates expected to outstrip the US’s and eurozone’s, there is, in theory, little stopping traders from piling into UK assets.
They need to buy up pounds to get their hands on those assets. That dynamic has been steering the pound’s strong 2023.
Pound/US dollar exchange rate this year
A strong currency endows well known advantages to an economy. It keeps inflation lower than it would’ve otherwise been by making it cheaper to import goods and services.
Consumers tend to feel more confident in their country’s economic prospects when surrounded by positive currency news.
In the UK, though, it can have damaging effects on the stock market. A large chunk of the FTSE 100 consists of firms who generate their cash overseas.
When the pound strengthens, it crimps the amount of cash these companies can make when exchanging their overseas income (known as foreign exchange arbitrage). UK exporters’ products also become less competitive.
Those factors have partly reversed the FTSE’s rampant start to the year.
But there are signs that the pound’s ascent is being arrested by recession risks reigniting.
Last week, sterling clocked one of its worst days against the dollar in a month, dropping 0.8 per cent.
“The timidity of sterling’s recent appreciation is puzzling,” according to Samuel Tombs, chief UK economist at Pantheon Macroeconomics. He calculates the currency should be trading at $1.40 and €1.24.
There are other factors traders have to consider if Bank Governor Bailey and co kick rates above six per cent.
Such a move would chill the housing market, intensify the real income squeeze and cool business investment, all of which raise the likelihood of a UK recession.
Pound/euro exchange rate this year
No one wants to be left holding the bag in a declining economy. Traders holding UK assets would be left doing so. Reasons to turn their back on the pound are back on the table.
Concerns about high inflation entrenching in the economy have amplified recently, which are partly outweighing any benefits traders expect to receive from steeper interest rates. Inflation is still far above the UK’s nominal interest rate.
This dynamic is what led to Liz Truss’s downfall. Her fiscal strategy was likely to keep inflation higher for longer and provide little stimulus to growth. There were very few incentives for people to pile into UK assets, sinking the pound to its record low.
Sterling has done well so far in 2023. But, much like the UK economy as a whole, it has underperformed due to persistent uncertainty about what risks lie around the corner.
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Where has this much-touted recession gone? Last week, the Office for National Statistics confirmed the UK economy grew 0.1 per cent in the first three months of this year, meaning we’ve narrowly avoided a recession in the first half. Pantheon Macroeconomics reckon it’s down to the changing structure of the mortgage market blunting the transmission of the Bank of England’s 13 successive interest rate rises and savers finally getting a decent return on their accounts. As a result, household income “has been boosted by the increase in interest rates so far,” they said in a note to clients.