FX Research: Perfect Storm For Sterling‏

We have seen a significant weakening of sterling this year and only the Japanese yen has performed weaker against the euro and the US dollar. GBP has lost 2.5% against USD and 5.60% against EUR. We argue that a perfect storm is in the making for sterling at the moment and that a further significant depreciation of sterling is highly likely. A move above 95 in EUR/GBP is certainly a possibility during 2013. In our view, sterling is under pressure and will come under further pressure for the following reasons.

First, it seems more and more likely that the Bank of England might try to boost the UK economy further in 2013. Mark Carney, who will take over as governor this summer, has surprised the market recently. He has been very outspoken and it seems obvious that he has a very pragmatic approach to monetary policy. He has, in recent speeches, been talking about nominal GDP targeting and, according to media reports, his more aggressive policy approach is co-ordinated with the government. His thoughts have spooked the currency market but we think that concerns about sterling and depreciation risk to GBP from a new monetary policy framework target have not all been priced in.

On top of the monetary policy uncertainty, the recent EU speech by David Cameron has also added to GBP uncertainty. In our view, the most important UK event next week will be Mr Carney’s appearance before the Treasury Committee on 7 February. He might say that a deviation from the ‘traditional’ inflation targeting can be beneficial under certain circumstances and probably stress the importance of communication as a monetary policy tool.

Second, there is growing concern that the UK might experience a triple-dip recession. GDP growth surprised to the downside in Q4, falling 0.3% q/q, and the outlook is not very promising. PMI manufacturing is pointing to a very weak recovery in manufacturing and PMI Services fell below 50 once again in December. We are concerned about the UK growth outlook and even though a global recovery and a weaker GBP should support growth, the recovery is expected to be moderate. If a possible UK recovery is in fact driven by a global recovery, GBP would anyway be expected to face cyclical headwinds. GBP is together with USD a so-called counter-cyclical currency that normally depreciates in a positive global growth and risk scenario.

Finally, the move higher in EUR/GBP is very much a euro recovery story. Since the ECB ruled out a new rate cut on 9 January and as banks have started to repay the LTRO money, European money market rates have moved significantly higher relative to corresponding UK rates. During January we saw the two-year swap spread between the UK and the eurozone widen by close to 30bp. But the euro recovery is not just a story about higher euro rates. It is also the story about less tail-risk attached to the euro. Over the past couple of months, we have seen a further tightening of peripheral spreads against Germany in the eurozone. Hence, the euro debt safe haven flows that supported sterling not least in H1 12 have, in our view, completely dried up.

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