News & analysis

From Monday’s lows to Friday’s high sterling rallied more than 9% against the US dollar last week, completing its best weekly performance since at least 2009.

Much of this move was simply an unwind of the extreme selling seen in previous weeks – sterling traded largely in line with other comparable currencies. Given coronavirus news and global trends are likely to continue to dominate global FX markets for the foreseeable future, we will not issue a firm “base case” outlook for sterling for now.

This note instead looks at two factors that are relevant to sterling – it’s place in the basket of comparable developed currencies, and the scope of the measures the Bank of England and Treasury have implemented.

The global spread and severity of the coronavirus pandemic has blown apart the base case in our most recent sterling outlook, which was released at the end of February. Since then, it has become clear that the virus will cause an almost unprecedented contraction in global growth. The dawning of this realization for markets prompted a sharp risk-off move in global macro markets, which manifested in spot FX as a massive wave for dollar strength. For sterling, which was already trading at low levels after several years of Brexit risk, the falls made for some eye catching headlines as GBPUSD reached its lowest level since 1984.

Key Views:

  • The short run outlook for sterling will remain dominated by the ongoing coronavirus pandemic and conditions in global macro markets. As the past two weeks have made brutally clear, the UK’s status as a small open economy with a current account deficit mean the pound remains highly vulnerable to periods of risk aversion and stress on US dollar funding.
  • In the medium run, the timeliness and the scale of the fiscal and monetary response means that the UK economy is likely to be well-placed relative to several of its peers when a recovery does eventuate.
  • For now, the BoE’s provision of USD liquidity appears to have eased USD funding pressure, while the promise of asset purchases has calmed gilt markets.

Looking ahead, further deterioration in global risk appetite may result from a further tightening of US financial conditions or evidence that the global outbreak has worsened significantly.

In this scenario, sterling’s lows from mid-March could easily be tested and broken. For instance, the 13.55% high to low fall for GBPUSD is significant, but smaller than the 28% depreciation seen in the second half of 2008.

Sterling likely to remain vulnerable to further risk-off shocks and dollar funding stress.

The recent performance of sterling makes it clear that global factors, namely risk aversion and dollar funding stress, were behind the rapid depreciation of the pound. Although for now both of these pressures have abated, further collapses in risk sentiment remain a serious risk to sterling, simply based on the UK’s status as a small open economy with a current account deficit. GBP may be more vulnerable at the margin than some other G10 currencies, due to a relatively large current account deficit that is usually financed by financial inflows, as well as the severity of the domestic coronavirus outbreak.

 

GBPUSD goes on wild ride

For most of January and February, the coronavirus outbreak was perceived by markets as primarily an economic shock for China. From early march onwards, the global spread of the outbreak and rising death count in Italy made it clear that drastic containment measures would be necessary in a wide range of countries, creating an unprecedented shock to global growth. Currencies traded in broad categories consistent with their macro characteristics: safe havens such as JPY, CHF, and EUR fared the best. Small developed economies with current account deficits such as GBP, AUD and NZD, suffered, with sterling’s losses proving particularly sharp in percentage terms. The heaviest losses came to oil-linked currencies such as NOK and CAD.

 

Selected G10 currencies VS USD

Aggressive UK policy response likely to cushion macro blow

The monetary and fiscal policy response to the coronavirus shock has been unprecedented in terms of speed, scale, and co-ordination, but at this point the baseline shock that they will be acting on remains unknown. Until the local outbreak begins to peak and its severity becomes better understood, the ultimate outcome of the mitigation measures is difficult to reliably quantify. We can, however, note that the BoE has succeeded in stabilizing gilt markets, and USD funding stress has been alleviated.

As far as mitigating the economic impact of the coronavirus, measures taken by the UK Government and Bank of England are likely to be a “best in class” solution both in terms of scope and timeliness:

  • At a special meeting on Thursday March 19th amid high volatility UK and global markets, the BoE announced a re-start of quantitative easing worth £200bn, cut bank rates to 0.1%, and enhanced its Term Lending Scheme. These measures were followed by a Covid Corporate Financing Facility in cooperation with the Treasury, which is aimed at providing emergency liquidity to corporates via purchases of corporate paper. A contingent term repo facility, aimed at providing liquidity for a broad range of collateral, as well as USD repos aimed at easing USD funding stress were also implemented.
  • Rishi Sunak announced a sweeping stimulus package on Friday 20th March that included an unprecedented pledge to pay 80% of inactive workers’ salaries. Combined with other cash transfers to businesses and a pledge to pay self-employed workers up to £2500 a month, direct fiscal stimulus in excess of £60bn is likely to be deployed in the next 3 months.

For now, the most tangible effect of these measures can be seen in UK gilt markets and cross-currency basis swap spreads, both of which are showing far less signs of liquidity stress compared to the middle of March. In terms of percentage changes in gilt yields, the volatility seen prior to the BoE’s intervention on the 18th March was unprecedented. For UK 10 year gilt yields, the five biggest daily percentage changes of the past 10 years all occurred in the past month. Since the BoE’s emergency measures on the 18th, both yields and daily volatility has fallen. The BoE has also been conducting USD repo operations aimed at improving domestic USD financing conditions. These operations steadily decreased in size from a total allotment of $8.5bn on the 24th to less than $1bn on the 27th. Over the same time period, cross-currency basis swap spreads narrowed, suggesting easing USD liquidity conditions.

 

UK 10 year Gilt yield volatility subsides after BoE intervention

 

Author: Ranko Berich, Head of Market Analysis 

 

 

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