Insight from our experts

Prospects for sterling in 2010

Paul Robinson
Quick Facts Name: Paul Robinson
Company: Barclays Capital
Position: Chief Sterling Strategist

Few businesses will mourn the ending of 2009. It saw the deepest recession since World War 2, and sharp increases in unemployment and both corporate and individual bankruptcies. The UK was not alone in its suffering, but it has been relatively slow to come out of recession, and the financial crisis, the housing market and the end of the long consumer boom have raised more questions about the future than for most other economies. It is therefore unsurprising that sterling has remained at a very weak level compared with its pre-crisis norm. The pound did appreciate to some extent against both the euro and dollar in 2009, but in both cases that was from an incredibly weak starting position.

Dramatic though the developments in 2009 have been, more important is what is likely to happen in 2010. In our opinion, while everything affects foreign exchange rates, two issues will dominate sterling moves: the relative monetary policy response in different economies as the recovery gains momentum and the prospects for government finances.

Monetary policy is likely to be the more important. The Bank of England (BoE) is currently adding to its quantitative easing (QE) programme. This entails buying assets from the private sector which it pays for by effectively printing money. Increasing QE therefore adds to already very loose monetary policy brought about by Bank rate being at an all-time low. But the current asset purchases are due to end in February and we expect no further extension. Increasingly, attention is likely to move to when monetary policy will tighten and what mix of interest rate rises and asset sales the Bank of England will choose.

An end to asset purchases would likely boost sterling. Though no great surprise, an announced “pause” of purchases while the MPC assessed the situation would be read as a signal to markets that the next move was highly likely to be a tightening of policy. It would also resolve the uncertainty about the decision. It is worth remembering that the surprise increase of purchases following the MPC’s August meetings led to the most recent bout of sterling weakness.

Once monetary policy does start to tighten in the UK, it could happen quickly. It is looser here, both through direct BoE action – interest rate cuts and QE – and because of the weakness of sterling and the surprising resilience of UK inflation (which has reduced the UK real interest rate further relative to other economies). There is a chance that UK monetary policy will move from being the loosest of any of the major economies to tightening more quickly than any other major economy. If so, sterling would likely perform strongly.

Fiscal policy is an increasingly important issue. In some ways the UK situation is not as bad as other G7 economies. Government deficits have increased in all the major economies, adding to large outstanding stocks of debt. The UK government’s initial stock of debt is relatively low and the inflation targeting framework should limit fears of inflation being allowed to pick up, thus reducing the real value of the government’s debt. But the UK has the largest deficit in the G7 and the imminent UK election adds uncertainty. Perhaps most importantly, the US remains the core of the global financial system, and Germany and France represent the heart of the euro zone. Of the large economies there would be less disruption to financial markets if the UK’s credit rating were downgraded. Discussions with investors make it clear that fiscal issues are weighing on GBP. Following the election they should abate, assuming reasonably prompt and decisive action by the ensuing government. But if not, this is a major downside risk for GBP, especially over the first half of the year.

Sterling’s weakness has reflected worries about the UK more than other countries’ strength and our main trading partners also face problems of their own. The US dollar accounts for over half of global official reserves, far greater than its share of the global economy. Diversification away from the dollar may therefore be an ongoing issue for it. And the euro appears to be significantly overvalued against a range of currencies, especially sterling.

Sterling weakness is generally portrayed as a sign of how bad things have become for the UK economy. Perhaps, but it has also helped the healing process, making it easier for UK growth to be supported by net trade. There remain significant uncertainties, especially surrounding the election and the UK’s troubling fiscal position. But overall, we think that the pound is likely to strengthen, though there is little chance of it moving anywhere close to its pre-crisis levels.

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