Sterling — Fuel for thought

I will be speaking on the “Fixed Income and FX” panel at the (virtual) Global Independent Research Conference on 13th October at 12.30 (UK time). Click here for further details.

We turned bullish GBP/EUR in late-June and re-reiterated our constructive view in mid-July and early-August and the cross duly hit a 76-week high of about 1.182 on 11th August.

In line with our expectations, historical monthly seasonal patterns were up-ended thanks in part to the positive impact of international travel restrictions on the UK’s tourism balance and the Bank of England turning more hawkish in absolute terms and relative to the ECB.

However, since then Sterling has weakened about 1.1% against the Euro and 1.5% in NEER terms, despite the Bank of England turning even more hawkish, markets now pricing almost three 25bp rate hikes in 2022 and a sharp widening of the Gilt-Bund yield spread.

The reason in our view is that Gilt yields have risen because of market expectations that UK CPI-inflation will rise from already elevated levels despite weak domestic economic growth, which renders UK financial assets (including Sterling) less attractive.

UK GDP growth slowed in July despite the government having removed on 19th July all but a few social distancing restrictions in England and PMI data suggest GDP growth remained weak in August-September. Notably the deceleration in economic growth in recent months was likely more pronounced in the UK than in the Eurozone, albeit from higher levels.

The UK economy faces a number of headwinds, namely i) acute labour shortages and supply-chain constraints and bottlenecks; and ii) multiple challenges to domestic demand.

On the demand-front the issue is not weak household purchasing power or strained corporate balance sheets but rather tepid consumer and business confidence as a result of planned tax increases in April 2022, furlough having ended on 30th September, fuel-shortages, rising CPI-inflation and likelihood that Bank of England will hike rates next year.

The risk is that the current shortage of fuel at forecourts will not be a one-off, in our view, because the ratio of vehicles to fuel forecourts has risen materially in the UK since 2000.

In the current context we find it challenging to build a bullish short-term case for GBP/EUR.

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