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?â€
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 powerâ€. This suggests less of a panic-stricken FX reaction going forward.
