Sterling’s strength could reverse before too long

Despite signs of a strong UK recovery, the pound may suffer from Fed tapering and an improving Eurozone, says Liam Ward-Proud

The pound’s enduring strength since the summer has caught many by surprise. Towards the end of June, with sterling-dollar just below $1.55, Morgan Stanley strategists expected it to fall to $1.45 in the third quarter and $1.41 in the fourth. Instead, the pound has risen almost inexorably (see graph). Sterling-dollar hit levels just shy of $1.64 yesterday, while sterling-euro and sterling-yen have risen by 1.54 and 12 per cent respectively over the last six months. But will this protracted strengthening continue?

“The major driver of sterling’s rise was initially the outperformance of the UK economy relative to expectations,” says Simon Smith of FxPro. But amid increasingly optimistic expectations of UK growth, it may be difficult for data to continue to surprise to the upside. Further, Smith says, lagging business investment and an over-reliance on consumer spending could catch up with the pound, potentially causing a reversal of some recent gains.

NO WEAKENING YET
However, there is a compelling argument for a further rally for sterling – particularly in the short term. “As long as the UK’s economic data continues to outperform its peers, we are likely to see further gains for the pound,” says Michael Hewson of CMC Markets. The UK jobless rate fell from 7.8 per cent to 7.6 per cent in the third quarter, and the Bank of England revised its unemployment forecast, saying that there is now a 50 per cent chance it would drop to 7 per cent at the end of 2014 – the level at which it would consider raising policy rates.

And according to Ashraf Laidi of City Index, “the Bank’s rhetoric suggests it has grown less reluctant to accept macroeconomic improvements and rising gilt yields, in contrast to the continued dovish stance from the US Federal Reserve and European Central Bank (ECB).” The perception that the Bank is further down the road to tightening than the Fed and ECB should underline further gains for the pound, says Laidi. It could even flirt with highs of $1.65.

INTERNATIONAL FACTORS
But it is by no means certain that the Fed will stay dovish for long. And even if UK data does continue to surprise to the upside, hints of tightening in the US could push the dollar higher against the pound. The non-farm payrolls report released last week showed that the US economy added 203,000 jobs in November, with the unemployment rate falling to 7 per cent, fuelling speculation of an earlier-than-expected December taper. “The dollar will do much better in the early part of next year as the Fed starts to pull back from buying bonds every month,” says Smith. The Fed has made pains to stress that any wind down in its $85bn (£52bn) a month of asset purchases does not constitute an outright tightening of policy, but Smith expects changes to the dollar’s value to take effect at the margin nonetheless. “I would see sterling moving below the $1.60 level against the dollar in the early part of 2014.”

Jane Foley of Rabobank, meanwhile, thinks that “it will be tough for the pound to make many further gains against the euro.” While there is next to no chance of the ECB tightening policy, she says that “there is a perception that the euro crisis is off the boil,” and this should stop the euro sliding much further against the pound. Smith sees sterling-euro falling back from its current level above €1.19 in early 2014, potentially to as low as €1.18.