After a poor performance so far in May, sterling is lagging most of its peers in the G10 group of currencies, with only the New Zealand dollar and Norwegian Krone registering bigger losses against the dollar so far this year.
In general, although we remain optimistic about sterling’s prospects for a gradual recovery against the greenback in Q3, a number of idiosyncratic drags on sterling may see the currency continue to lag its peers in the G10.
So far in May, sterling has been the worst performing G10 currency against the US dollar. In practical terms, GBPUSD has trended downwards after two failures to sustain rallies above the $1.25 level. Against the euro, the pound has depreciated more than 3.5% this month.
Looking ahead, the most likely trajectory for the second half of the year in global macro markets is a gradual recovery in risk appetite as economies re-open. We believe the G10 currencies as a whole are likely to continue to recover this year, sterling included. The greenback continues to trade at high levels in historical terms, while the Federal Reserve has significant political and practical room to expand monetary easing when needed. However, although the G10 as a whole has good grounds for a rally against the dollar, we are less optimistic about sterling’s relative performance among its peers. The reasons for this are, in order of importance: a severe domestic covid-19 outbreak and the risk of longer lockdown measures, an activist Bank of England with more room to loosen policy, and ongoing Brexit uncertainty.
Sterling lags most of G10 peers
Exchange rates normalised to a value of 100 as of 31st December 2019
THE MPC WILL EXPAND QE IN JUNE, AND MAY LOOK TO NEGATIVE RATES IF A SLOW RECOVERY OR A SECOND COVID-19 WAVE FORCE ITS HAND
The UK economy will see a historically bad second quarter in terms of gross domestic product growth. However, this will be a common feature of many major economies, so the extent to which it will contribute to sterling weakness is unclear. A better guide to sterling performance may be the outlook for the easing of lockdown measures in Q3 – where the UK may lag several peers due to its severe domestic outbreak.
Initial survey and hard data suggest that the decline in Gross Domestic Product during April, which the UK spent fully under expansive “stay at home” restrictions, was in the order of 20%.
However, both official and private macroeconomic forecasters expect a rapid recovery in the third quarter and beyond. The Bank of England anticipates a complete recovery to 2019 GDP levels by the middle of 2021, beginning with a rapid bounce in the third quarter.
The MPC has so far been reticent to consider negative interest rates and is unlikely to do so in the near future. Given that current asset purchases are likely to reach their announced £200bn limit in mid-July, an expansion in QE is highly likely to be announced at June’s MPC meeting. Indeed, it has been all but officially announced in a series of hints from policymakers. However, should the much-anticipated “v-shaped” recovery in Q3 begin to falter, the MPC will give more serious consideration to negative interest rates. The UK’s high case count and the risk of a “second wave” of infections suggest that significant restrictions could remain in place for longer than expected in Q3. More QE is likely to be the MPC’s first recourse in this scenario, but recent comments from policymakers suggest that negative rates are less inconceivable than they once were. After saying that the MPC are not “planning for or contemplating” in a Webinar on the 14th of May, Andrew Bailey acknowledged in a testimony to lawmakers on the 20th May that the policy measure was under “active review”.
BREXIT IS STILL A FACTOR
Although many market participants (and readers, and analysts) are suffering from “Brexit fatigue”, it is worth noting that initial signs from negotiations for future trade relations with the EU have not been positive, presenting another downside risk for sterling. The general situation is a familiar one to long-time followers of Brexit: the Northern Ireland border remains a sticking point, UK proposals are being rebuffed as unrealistic, and the clock is ticking. Although in our view the most likely outcome remains a modest free-trade agreement, the sharp time constraints and significant differences in opinion on the key issue of the Irish border means the issue will remain a risk for sterling.
Author: Ranko Berich, Head of Market Analysis