By - Jan 18, 2011 6:11 PM GMT+0800
Mervyn King, governor of the Bank of England. Photographer: Chris Ratcliife/Bloomberg
No major currency is performing worse than the pound as Prime Minister David Cameron’s budget cuts slow growth and rising inflation limits the Bank of England’s ability to spur the world’s sixth-largest economy.
Sterling has weakened against all 16 of the most-traded currencies, depreciating even more than the euro, since the start of August. The three most accurate strategists for the pound expect it to continue falling and futures traders this month were the most bearish since September.
The pound, which appreciated 8 percent against the dollar after Cameron took power in May until November, has been trapped by the government’s efforts to close a deficit that grew to 11.1 percent of gross domestic product in the last fiscal year. Bank of England Governor Mervyn King is keeping interest rates at record lows to spark growth at the same time that inflation has remained above the government’s 3 percent limit for nine months.
“Tightening policy to rein in inflation in a weak-growth environment would be a double whammy against the pound,” said Lee Hardman, a strategist at Bank of Tokyo-Mitsubishi UFJ Ltd. in London. “Rate hikes are currency supportive only if they’re consistent with stronger economic growth.”
The currency will probably fall to $1.50 by year-end, he said. The pound climbed 1 percent to $1.6045 as of 10:08 a.m. in London. Analysts have been cutting their forecasts for the pound versus the dollar this year, with the median of 29 estimates compiled by Bloomberg predicting sterling will end 2011 at $1.54, down from $1.59 at the end of last year.
Top Priority
Cameron made the deficit the top priority after Standard & Poor’s threatened to lower the U.K.’s AAA credit rating in May 2009. S&P affirmed the top ranking after Chancellor of the ExchequerGeorge Osborne presented the program of reductions in October. The government is cutting welfare spending and public- sector jobs, while raising taxes and tuition fees.
The pound weakened 7.14 percent last year, and fell 4.04 percent from Aug. 3 through yesterday, according to Bloomberg Correlation-Weighted Currency Indexes. It depreciated 2.7 percent against the dollar the past two months, the most since the election that brought Cameron’s Conservative-Liberal Democrats coalition to power in May. Sterling rose 2.07 percent against the dollar last week, while it weakened 1.58 percent against the euro.
Futures traders increased bets this month the pound will weaken against the dollar, figures from the Washington-based Commodity Futures Trading Commission show. The difference in the number of wagers by hedge funds and other large speculators on a drop compared with those on a gain, so-called net shorts, was 14,133 on Jan. 4, the most since Sept. 7.
Bond Losses
U.K. bonds are also suffering. Gilts have lost 3.92 percent on average the past three months, exceeding losses of 2.71 percent for U.S. Treasuries and 3.08 percent for German bunds, Bank of America Merrill Lynch index data show.
Osborne said in October that eliminating most of the 156 billion-pound ($248 billion) deficit by 2015 was essential to prevent a loss of investor confidence. His plans would reduce public spending by 81 billion pounds after inflation, narrowing a deficit the government forecast at 10.1 percent of GDP this year to 2.1 percent in the 2014-15 fiscal year.
Growth is already slowing. The U.K. economy, which expanded 0.7 percent in the three months through September, may increase 0.2 percent to 0.3 percent in the first two quarters of this year from an estimated 0.4 percent in the fourth quarter of 2010, according to the British Chambers of Commerce.
Rate Outlook
That will keep King from raising borrowing costs, leaving the U.K. with negative rates after accounting for inflation, according to JPMorgan Chase & Co. Gilts due in 10 years yielded 0.32 percentage point more than the U.K.’s inflation rate as of yesterday. By comparison, Treasury 10-year notes yielded 1.83 percentage points more than the increase in consumer prices, compared with 0.84 percentage point for German bunds and 1.11 percentage points for Japanese government debt.
“We expect the pound to continue to be an underperformer within Europe,” said John Normand, London-based head of currency strategy at JPMorgan. Bank of England policy makers “act as if they have a stronger emphasis on growth,” he said. “If that’s the case, they are not going to be raising interest rates even though inflation stays above target. Sterling is a currency with a negative real interest rate.”
While the Bank of England’s main rate has been a record low 0.5 percent since March 2009, a central bank report on Dec. 16 showed Britons’ inflation expectations surged to the highest level in more than two years.
Faster Inflation
Analysts predict U.K. inflation will surpass other developed nations this year. Consumer price growth will reach 3.10 percent, according to the median estimate of 15 forecasts compiled by Bloomberg. Gains will reach 1.70 percent in the U.S., 2.10 percent in Canada and 1.60 percent in Germany and France, surveys show.
The pound weakened against the euro since August even as leaders from the common-currency region grappled with a debt crisis that forced Greece and Ireland to seek financial aid. Ministers met yesterday in Brussels to discuss ways to strengthen their rescue fund for debt-stricken states.
The U.K.’s inflation rate jumped to 3.7 percent last month, the fastest pace since April, from 3.3 percent the previous month, the Office for National Statistics said today in London.
Relative Yields
Pound bulls are enticed by high relative yields, which are likely to keep moving in the U.K.’s favor as the Federal Reserve prints cash to finance purchases of $600 billion of Treasuries. Two-year gilts yield 0.81 percentage point more than Treasuries of similar maturity, near the most since January 2009, from almost no difference in April.
The Bank of England is unlikely to risk its inflation- fighting credibility, said Paul Robinson, London-based head of European foreign-exchange strategy at Barclays Plc’s investment- banking unit.
“The Fed is going to carry on talking dovish whereas the Bank of England is going to be forced into tightening policy,” said Robinson, a former economist at the U.K. central bank who predicts sterling may advance to $1.82 by year-end. “At the end of the day the inflation target is not a growth target.”
The implied yield on three-month short sterling futures contracts expiring in September has climbed 29 basis points since Dec. 31 to 1.34 percent, signaling investors are adding to bets that borrowing costs will rise.
‘Borrowing a Burden’
About two-thirds of outstanding mortgages are tied to the Bank of England’s main rate, according to a Dec. 17 Bank of England report.
“Many unsecured borrowers, particularly mortgagors with limited equity, are already finding current borrowing a burden,” the central bank said in its Financial Stability Report.
The opposition Labour Party won a special election in a northwest English parliamentary district last week and Cameron’s Conservative Party lost support in the area.
“We tend to look at any form of BOE policy firming as an untimely headwind for the U.K. economy,” said Stephen Gallo, the head of market analysis at Schneider Foreign Exchange inLondon. “It’s not a good situation to be owning the currency when the central bank is behind the curve on inflation.”
Recession Risk
Schneider, the third-most accurate forecaster for the pound against the dollar in the six quarters ended Dec. 31, as measured by Bloomberg data, has the most bearish outlook for 2011. The firm says sterling will weaken to $1.35 by year-end.
San Francisco-based Wells Fargo & Co., the most-accurate forecaster of the pound against the dollar, predicts it will depreciate to $1.53, and No. 2 Vadilal Enterprises Ltd. in India sees it dropping to $1.50.
The U.K. economy faces a 20 percent chance of slipping into another recession as rising unemployment and faster inflation weigh on growth, the Centre for Economics and Business Research said Jan. 14. The London-based research group had earlier said there was a 10 percent chance of GDP shrinking. The unemployment rate was 7.9 percent in the three months through October.
Mark Farrington, who oversees $6.2 billion as head of currencies at Macro Currency Group, a unit of Principal Global Investors Europe Ltd. in London, said while a Bank of England rate increase may initially prove positive for sterling, any gains would be short-lived.
“It would deliver a shock to the household sector,” he said. “It’s possible sterling could have an initial surge, but after the initial shock the direction of the pound would probably be lower, at least against the dollar. We’re leaving sterling alone at the moment.”
To contact the reporters on this story: Paul Dobson in London at pdobson2@bloomberg.net; Lukanyo Mnyanda in London at lmnyanda@bloomberg.net.
To contact the editor responsible for this story: Daniel Tilles at dtilles@bloomberg.net.
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