Analysis: Risk of messy trade war adds to woes for British currency

While the challenges facing the UK economy are broadly similar to others, a few factors additionally weigh on the pound, writes Saikat Chatterjee.
Analysis: Risk of messy trade war adds to woes for British currency

'The pound has the weakest outlook among all the major currencies,' said Kaspar Hense, at Bluebay Asset Management in London.

In volatile currency markets, one trade stands out as an easy bet: Selling the British pound.

With the world's fifth-biggest economy grappling with a particularly unhealthy cocktail of slowing growth and surging inflation, sterling has become the medium of choice to express a negative view.

Official data showed UK inflation reached a 40-year high of 9% in April, while Britain's worst cost-of-living crisis in three decades will not subside until late this year, according to a Reuters poll. 

And though the Bank of England was the first among major central banks to raise interest rates in December, now their predicted future path is far less steep than some of its global peers, including the US Federal Reserve.

While the British economy's problems are broadly similar to what other policymakers are grappling with, a few factors additionally weigh on the pound.

One is the potential for a messy trade conflict with the EU if Britain threatens to push ahead with a law to override parts of a post-Brexit trade deal for Northern Ireland. Any protracted trade war would threaten to widen the current account deficit further and subsequently weaken the currency.

Then there is an increase in tax burdens, which followed massive temporary relief for struggling sectors during the pandemic and which has hit workers and employers already saddled with surging energy bills, adding to the drag on the economy.

The chance of a UK recession is all but guaranteed, as there are just too many headwinds facing the economy," said Wouter Sturkenboom of Northern Trust Asset Management.

Jane Foley, head of FX strategy at Rabobank, said markets have slashed their UK rate hike expectations in recent weeks because recession risks have grown. Respondents in a Reuters poll assign a 35% probability of a recession within a year.

Kaspar Hense, at Bluebay Asset Management in London, said he was short the currency in his portfolios. 

"The pound has the weakest outlook among all the major currencies as the central bank's reluctance to raise interest rates aggressively means it has the lowest inflation-adjusted yield among its rivals," he said.

Headwinds

As the war in Ukraine added more fuel to price pressures, UK growth expectations and consumer confidence tumbled. Citibank indexes that measure how economic data fares compared with expectations are lower for Britain than for the rest of Europe or the US, suggesting growing economic headwinds ahead.

That suggests that any British rate hike cycle will be short-lived. 

The consumer outlook has taken a big turn for the worse as the real income squeeze bites hard, and this will make it very difficult for the Bank of England to deliver anything close to what is priced into the forward rates market," HSBC said.

HSBC now expects sterling to end the year at $1.20, some 8% weaker than its earlier $1.30 forecast. On Wednesday, the pound was trading at $1.24. The British currency's transformation into a poster child for the stagflation risks facing the global economy has been swift.

In early December, hedge funds still were still betting against the dollar and favouring the pound. Six months later that has completely flipped to the biggest short pound bet in more than two and a half years. 

The outlook remains bleak, markets suggest. 

Reuters  

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