Sterling has experienced six difficult months, falling substantially against most of the other major currencies, including the euro. The latter broke above 71 pence in November, and hence out of the long established trading range. It has powered ahead since then, briefly pausing around 74 pence before establishing a new high of just under 81 pence a week ago according to Bank of Ireland’s April Bulletin which was published today.
Author of the Bulletin, Dr. Dan McLaughlin, Group Chief Economist, Bank of Ireland said: “The pace and severity of the move has been surprising (six months ago the consensus forecast for euro/sterling was 70 pence for mid-2008), and begs an explanation. One factor is the differential in interest rates, which has swung against sterling. Last autumn, the UK Bank rate was 5.75% against a repo rate of 4% in the eurozone, but this differential has now narrowed to 1% following three rate reductions by the Bank of England. Moreover, the market now expects euro rates to remain at 4% for the rest of the year, while pricing in another half point cut in the UK, taking the discrepancy in favour of sterling to only half a percentage point.
“The consensus growth forecasts for the two economies are similar (around 1.6%) which should not be overly supportive of the euro, but these do imply a more pronounced deceleration in the UK, given that growth there last year was 3%. In addition, the housing market in the UK plays a more significant role in the economy than in the other large European countries, implying greater perceived vulnerability in the current credit crunch climate. The dislocation still evident in the banking sector may also be seen as negative for the City of London and therefore for the UK economy as a whole, implying that sterling is also acting as a bell weather for financial market sentiment. It is also the case that the UK Government’s popularity has fallen in the polls and that policies have been introduced which are seen as negative for non-domiciled residents.
“Sterling’s fall has not raised alarm bells in policy circles as the Bank of England seems to believe that the UK economy needs rebalancing, with resources moving away from consumption and towards exports and investment. All told then, not a recipe for a strong rally in sterling, but it does now appear significantly oversold and undervalued. Consequently, we expect a partial reversal taking it back to 75 pence against the euro in the coming months, although it remains vulnerable to another lurch downward in the credit cycle”, concluded McLaughlin.
