It’s not been an easy year for the pound given the fallout from the June “Brexit” vote and there was certainly a concern 12 months ago that the uncertainty surrounding that vote was starting to weigh on some business investment decisions as well as inward capital flows into the UK.
There was certainly some concern about a potential slowdown in momentum of the UK economy when a lot of the headlines were about the sharp declines in commodity prices which in turn were causing ripple out effects in the form of large numbers of job losses in the oil and gas sector as well as the well documented problems with UK Steel.
The pound had already been under pressure heading into 2016 in any case having been on the slide since the Scottish referendum in 2014 against its major trading partners, only managing to post a positive performance against the euro and Australian dollar in 2015 largely as a result of further easing from both the ECB and the RBA.
The currency was also being weighed down by a weak inflationary outlook as expectations of a potential rate rise continued to diminish, while the US Federal Reserve was widely expected to build on its first rate increase in 9 years in the wake of its December 2015 rate decision.
We were also starting to hear the drum beat of hot air from politicians about the risks of the referendum vote and the possible negative outcomes of a vote to exit from the EU, and this did remain a concern in the lead up to this year’s vote. If you repeat a lie often enough it starts to weigh on the individual psyche and we heard a lot of lies and exaggeration from both sides of what was a shameful campaign.
Those concerns aside economic projections for this year were for GDP growth of 2.2% for 2016, at the end of last year, though there was a worry that turmoil in emerging markets might cause some problems in the short to medium term.
These GDP projections were swiftly adjusted lower in the aftermath of the June vote, however as things stand they still look to be on track to come in on more or less where they were expected to be at the end of last year, even if the GDP outlook for 2017 has been adjusted lower.
Source: CMC Markets
As we can see from the chart above we did see a significant downward adjustment in the aftermath of the June vote, with a lot of the initial weakness coming about as a result of the actions of the Bank of England in the days after the vote as the government went missing for several weeks.
These necessary actions from the central bank to add liquidity helped smooth out the initial surprise effect of the outcome though the initial decline was also exacerbated by the sharp rise in the pound in the week leading up to the vote, as the market got caught on the wrong side of the eventual result.
While the political vacuum in the aftermath of the vote was swiftly filled it soon became apparent that the government had made no contingency for a “leave” vote, and the effect of this was borne out by some very disappointing business surveys in the aftermath of the vote as economic surveys pointed to a sharp shock to confidence.
This shouldn’t have been a surprise given the political vacuum in the aftermath of the vote and the timing of the surveys, but given that we got a new Prime Minister quite quickly there was a more than even chance that this would be temporary and it did indeed prove to be the case, with a lot of informed opinion making that very point and urging caution on the Bank of England’s part with respect to their next policy response.
The Bank of England in any event chose not to heed some of these warnings embarking on what could be argued was a misguided rate cut and large scale QE increases, as well as a commitment to cut rates further by year end.
The effects of these measures have proved to be very short lived and can only really be seen in the exchange rate as the interest rate effects have disappeared, on higher inflation expectations, while the commitment to cut rates further has quietly been dropped.
With Article 50 still yet to be triggered the Bank of England has arguably wasted a potential rate cut in order to reinforce their pre and post Brexit narrative of an economic shock, and made it more likely that the next move in rates might well be higher.
As we look ahead to 2017 what does the outlook for pound now hold, given that sentiment even now still remains extremely bearish with a lot of targets projecting a GBP/USD rate of below $1.20 by the end of the year, and parity against the euro.
Source: CMC Markets
Certainly 2016 has been a bad year for sterling, however to suggest that further declines are inevitable is to ignore the problems elsewhere in the world.
Currencies don’t operate in a vacuum and with Donald Trump winning the US Presidency and all of the potential for further problems in Europe further sterling weakness is not the done deal many would have you believe.
Now that the Federal Reserve has raised rates, speculation is now shifting to the timing of the next one or two, and while markets were caught badly offside by the belief that we’d get four rate rises this year, even now expectations are rising that we’ll get more than two next year, due to the rising inflation outlook, and the Fed's glide path in the dot plot projections.
That we are sitting here now having only seen one rate rise you would have thought the Fed would have been slightly more cautious in their outlook, and allowed themselves a little more wriggle room, even if the outlook economically is somewhat different.
While it is never wise to take the dot plot projections at face value, quite frankly they’ve been a lousy guide to what the Fed has actually done in the past few years, they do nonetheless paint a picture of how US policymakers see the US economy, though it is important to note they pay no regard to how external events can and do influence Fed policy.
That being said the technical break of $1.3600 which was the previous 35 year low for sterling is a negative development and one that cannot be ignored, which would suggest that any sterling rebound is likely to be capped anywhere near there, with resistance also at $1.2880 the initial lows in the wake of the August rate cut and stimulus package.
The political situation in Europe also remains fraught which means the upside for the euro is likely to remain difficult to sustain with the solvency of the European banking sector an ongoing sore, and that’s before you price in the uncertainty of elections in the Netherlands, France and Germany, along with all of the uncertainty in Italy.
In short the next twelve months are likely to be choppy ones for the pound, and while further weakness cannot be ruled out the rebound since the October lows would appear to suggest that an awful lot of the bad news may well be already priced in, particularly since the higher inflation outlook is likely to make further rate cuts unlikely in the medium term.
We’ll probably get a clearer picture of the overall outlook for sterling as we head towards the end of Q3 as the deadline for triggering Article 50 gets closer.
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