How sterling surprised us all
The rebound in sterling has surprised a lot of people.
This week the pound rose to its highest level since April 2022. Stronger than expected gross domestic product, manufacturing and jobs data, a fall in the price of natural gas, and broad weakness in the dollar have all contributed to the sterling comeback story.
It’s been a case of headwinds (especially natural gas prices and central bank policy) turning into tailwinds.
Turn up for the books
Time moves fast in currency markets. It wasn't long ago (weeks, not months) that economists were berating the UK economy and predicting a recession (or underperformance at the very least). When GBP hit £1.03 last September it felt like a real capitulation, and you couldn’t find anyone bullish on the UK or its prospects.
In the past 7 months however, the UK has defied expectations, avoided recession (so far), and GBP has surprised to the upside. Consensus GDP expectations have been revised up, the economy has beaten them with economic surprises entering positive territory at the start of March.
Add into the mix recent inflation prints (10.1% in the UK, 4.9% in the US, 6.9% in the Eurozone), and the scope for further rate rises in the UK becomes clear – giving further upside to GBP’s potential.
Expectation management
This outperformance is partly a case of successful expectation management. It hasn't been hard for the UK economy to exceed expectations because the central bank has set those expectations so low.
The Bank of England’s forecast for the longest UK recession in one hundred years – eight successive quarters of shrinking output – and a peak-to-trough decline in UK output of 2.9% now looks set to be very wide of the mark.
The inflation story
The slightly less comfortable aspect of sterling’s comeback story is the fact that those inflation figures may continue to diverge as we carry on through 2023, with the US and Eurozone “winning” the battle against inflation much sooner than the UK does.
Wage-push inflation is ultimately solved by increased slack in the labour market (in addition to interest rate rises). The US is a single market of 330 million people, so a few waves of layoffs can introduce reasonable slack and reduction of aggregate demand. The Schengen Area of the EU represents nearly 420 million people, so again, the movement of people can introduce labour market slack.
After Brexit, the shortage of labour in the UK is palpable – whether it’s nannies or software engineers. As a small island nation (that has now cut off its largest trading partner), the risk of persistent inflation is much higher here in the UK, as we import so much more.
Known unknowns
All that being said, apparently 700,000 fixed rate mortgage deals are set to reset this year, which will definitely impact consumer spending. Will the majority of borrowers be able to weather the larger mortgage payments? Or will they be forced to sell/downsize?
Is the recession actually coming – just delayed? Or is inflation the biggest threat, and should the BoE be even more aggressive in rate rises until it falls down definitively?
Some tough questions ahead for the Old Lady of Threadneedle Street… I don’t envy Andrew Bailey!
