Sterling briefly pushed to 2-month highs against the dollar this week, but is likely to be increasingly vulnerable over the remainder of 2013. The stronger domestic growth trend has been priced in and gains will be even harder to make once short-covering fades. Bank of England Governor Carney will also look to exert forward guidance and push longer-term yields down. There has been heavy selling pressure on emerging-market currencies running current account deficits and the UK deficit will make Sterling increasingly vulnerable, especially as the underlying budget situation also remains precarious. Overall, losses are likely to extend back to at least the 1.50 area against the dollar by late September.
Sterling recovered from late-July lows beyond 0.87 against the Euro to trade around the 0.8550 area while the UK currency also pushed to eight-week highs against the dollar with a peak just above the 1.57 level. There has been evidence of Sterling demand as a safe-haven from emerging-market stresses. Nevertheless, it is very unlikely that there will be sustained demand for Sterling on defensive grounds.
A key feature of emerging-market currency vulnerability has been the issue of current-account deficits and financing concerns. The Indian rupee has been the most notable casualty of the recent stresses with increasing concerns surrounding the current account deficit. Indonesia, Brazil and Turkey have also recorded sharply weaker currencies and are also running current account deficits with the Turkish deficit running at above 6% of GDP.
In this environment, the UK is not in a comfortable position. The latest quarterly data again registered an annualized current account deficit of over 3.5% of GDP after a shortfall close to 4% of GDP during 2012. Any wider focus on balance of payments vulnerability will leave Sterling exposed.
The latest government borrowing data was weaker than expected with the weakest July figure for three years. The UK data is plagued by distortions such as asset sales and quantitative easing receipts from the Bank of England. Nevertheless, all measures of the budget deficit for the first four months of fiscal 2013/14 were higher than last year. Although bond yields are rising from a very low base, it is also the case that interest payments will increase which will have a negative impact.
There has also been an important increase in US bond yields and a steepening of the US yield curve over the past few weeks, again a factor which has tended to undermine the UK currency on previous occasions. Although UK yields have risen to the highest level in two years with 10-year yields above 2.70%, relative yield spreads have not improved significantly and real yields are likely to remain negative as above-target inflation is tolerated.
The UK currency will benefit to some extent from the much more optimistic economic tone over the past few weeks. There is, however, an important risk that the gains will not be sustainable given the weakness in personal disposable incomes, especially as the export base is not strong enough to provide wider economic support. The economy will also be undermined by a further decline in oil production this year, in contrast to a sharp increase in US production.
Concerns over the sustainability of the economic recovery will also be an extremely important focus within the Bank of England. Governor Carney introduced forward guidance in order to boost corporate and personal confidence in the sustainability of lower rates. There will certainly be important reservations if gilt yields continue to increase. There is the possibility that further quantitative easing will be considered and there is certainly the potential for further verbal intervention to push back against rising yields.
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