Drop in GBP/USD short-lived?

Last week the Bank of England (BoE) announced it intends to buy another £50bn worth of British government bonds. Even though this had already been discounted, GBP/USD (now around 1.55) fell sharply. Partly on safe haven flows into the USD and partly on growing concerns over the health of the British economy.

 

For the reasons below, GBP/USD is likely to drop further in our view.

Fundamentals point to sterling weakness

The British banking sector is sitting on 30% more reserves than regulators demand: A sign that the banks are very wary of supplying credit in the private sector. Now the government, together with the BoE, has announced measures to boost credit supply. (Such as looser collateral requirements for the banks in lieu of liquidity and cheap loans on condition that they will use the money to lend to households and businesses.)

 

Such programs are meant to boost the economy. However, most analysts think they merely serve to prevent a deeper recession against a background of further austerity. On top of this, Britain’s trade balance is deteriorating as Germany, its most important EMU trade partner, also starts to crumble under the weight of the euro crisis. In recent months, the pound has appreciated in trade-weighted terms, which is undermining the position of British exporters and companies trying to compete with foreign rivals. Then only the private sector can still generate growth, in theory at least. To do so, it needs access to credit. At the same time, households are trying to pay off outstanding debt instead of borrowing more. In other words, the demand for credit in the private sector is low. Therefore, the BoE and the UK government can take all the measures they want, and compel banks to pass on the recent rate cuts to the private sector, but this will not boost growth substantially. Meanwhile, such measures tend to pump more pounds into the banking system. The result is downward pressure on the value of the currency.

 

Additional cutbacks and deteriorating public finances will also place pressure on sterling. The government’s estimates for debt and deficit reduction are based on a higher tax take and other government earnings in a climate of higher economic growth and business investment. Sluggish growth means such a hopeful scenario is out.

 

All in all we expect the pound sterling to become less attractive as an alternative to – especially – the euro. On top of this the BoE will likely purchase more British government bonds to prevent Gilt yields from rising and the public finances from spiraling out of control.

 

The BoE has announced the latter before the details of its credit supply boosting measures were known. This could mean it is very worried about the negative effects of mounting eurozone tensions on the British economy and banking sector. As the situation continues to worsen and threatens the UK economy (further) we foresee more monetary easing.

 

Depreciation vis-à-vis USD

All of the above will weaken sterling, especially vis-à-vis the greenback. Not least because – unlike the BoE – the Fed will probably wait a while before implementing quantitative easing (it wants to keep its powder dry). Speculation on QE III could send GBP/USD higher, but once the Fed does less than investors expect, the currency pair could head south. After all, the US dollar still seems the safest bet as the euro crisis deepens.