February 14, 2013 3:45 pm

Risks of weaker sterling have increased

Sterling fell to multi-month lows against the dollar and the euro this week after the Bank of England raised its inflation forecasts and signalled that it would not tighten monetary policy in the near-term. But what might the coming months hold for the pound?

Thu Lan Nguyen

“Weak growth plus high inflation equals weak sterling,” says Thu Lan Nguyen, FX strategist at Commerzbank. “That is certainly what the Bank of England’s latest inflation report is suggesting.

“The Bank’s new inflation outlook is much higher than the November projections. But as the rise in inflation is due to factors outside its control, it is unlikely to actively fight inflation.

“Instead, the outgoing governor, Sir Mervyn King, pointed out that “if necessary [the central bank] would do more”.

At the same time, it would have to be clear though that the ability of monetary policy to stimulate the economy is limited.

“Sir Mervyn nonetheless signalled that the door would remain open for further expansionary monetary policy steps – despite continued high levels of inflation. It is hardly surprising therefore that sterling has come under pressure.

“There is very little pointing towards a sustainable recovery of the UK currency at present. Instead, resistance at £0.87 per euro is already back within sight.”

Chris Turner

Chris Turner, head of foreign exchange strategy at ING, says it has been clear for some time that the Bank has wanted a weaker pound to rebalance the economy towards the export sector.

“Now, however, it seems that Sir Mervyn is sowing some serious doubt in the minds of bond investors too,” he says.

“The shift to ‘flexible’ inflation targeting, effectively ignoring above-target inflation for the next two years, seems to have hit Gilt prices. And given foreigners own around £400bn of Gilts and the UK runs a large current account deficit, the Bank could be playing with fire,” he adds.

“We have been bearish on sterling/dollar for a long time but we had certainly not envisaged the euro rising this far against the pound. It is not our preferred call but, if Sir Mervyn misjudges the mood of investors and risks triggering a sharp exit from the Gilt market, sterling could fall a lot further against the single currency – even as far as £0.90 per euro.”

Camilla Sutton

Camilla Sutton, chief FX strategist at Scotiabank, notes that the pressure on the pound against the euro has intensified in the wake of weaker than expected eurozone GDP data.

“Contraction in Europe will weigh on UK exports,” she says.

“Sir Mervyn King’s announcement that inflation was now expected to run above target for two years but that the Bank would look through this inflationary pressure in setting monetary policy has positioned the UK on a razor’s edge.

“There is a risk that inflation expectations become unhinged and the credibility of the Bank comes under pressure. Our bullish view on sterling is looking increasingly difficult to maintain. We had expected that Bank of England policy would prove less aggressive than that of the Federal Reserve but that now looks less certain.

“As Mark Carney enters the Bank as new governor, we are unwilling to abandon our bullish call but recognise that the risk of more sustained weakness in sterling has increased.”

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