Do not be fooled by sterling’s recent rally

strong>And a weaker pound isn’t helping to realign the UK economy

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STERLING bulls have not had a lot to cheer about in recent months. The pound tumbled from January highs near $1.64 against the dollar to $1.48 in March, and from €1.24 to €1.16 against the euro, on the back of the UK’s dire economic fundamentals.

However, sterling has rallied since mid-March, now sitting at $1.53 against the greenback and €1.18 against the euro. And there have been some encouraging signs lately, giving fuel to the bulls.

For instance, the UK’s services sector – accounting for 77 per cent of GDP output – grew at the fastest rate for seven months in March. And there was also good news for chancellor George Osborne last week, as S&P decided not to join Moody’s and Fitch in downgrading the UK, albeit keeping it on negative watch.

Sterling bears have been rattled. After increasing for six consecutive weeks, net sterling speculative short positions eased last week. But should sterling’s recent rally be taken as a sign of a turnaround in fortunes, or is it just a temporary reprieve?

BEING PULLED

Sterling’s recent rally against both the dollar and the euro has not been driven by the UK’s own economic performance. “It is probably difficult to find UK-specific factors that drive sterling,” said UBS’s Geoffrey Yu.

The dollar index has dipped since mid-March, showing that the buck is under pressure against a wide basket of currencies – not just the pound. Much of this is due to the US’s fiscal sequester, where $90bn (£59bn) of budget cuts became effective on 1 March.

While this is likely to drag on US economic growth, Ian Stannard of Morgan Stanley does not think it warrants selling sterling-dollar, which he sees falling to $1.41 by the year-end. “We would expect sterling to come under pressure as the change in Bank of England leadership approaches, and the market anticipates a more pro-active [monetary] approach.”

If incoming governor Mark Carney takes a leaf from the US Federal Reserve or the Bank of Japan, his reign over Threadneedle Street will be aggressive. This may include using quantitative easing to buy mortgage securities (like in the US), and more extreme methods to improve business funding. But ramping up the money supply will stoke inflation, which is what worries traders, since it will be sterling negative.

Against the euro, sterling’s rise has coincided with the return of the Eurozone crisis, which reignited fears about contagion and the safety of bank deposits in the Eurozone’s periphery. In addition, European Central Bank (ECB) president Mario Draghi recently confirmed speculation that the ECB had “extensive discussions” about easing monetary policy, possibly through a rate cut, which has contributed to euro weakness.

Nevertheless, Stennard still expects sterling to weaken against the euro too. “Sterling continues to appear particularly unattractive compared to its G10 peers. A euro-sterling rebound back to the recent £0.88 [€1.1363] highs, and even the £0.90 [€1.1111] area is possible.”

WEAK STERLING HAS NOT HELPED

Not all UK economic data has been positive. Notably, last week’s construction and manufacturing purchasing managers’ surveys showed that the sectors are still contracting.

The manufacturing data will concern Bank of England governor Sir Mervyn King, who recently argued that manufacturing exports would help to rebalance the UK’s economy, and improve the trade deficit. Many – including King – have argued that a weaker sterling was pivotal to this. But in reality, it has done little to help.

On a trade-weighted basis, sterling is now at similar levels to where it was after the UK was ejected from the European exchange rate mechanism in 1992. That particular devaluation did help exports, and the UK subsequently swung into a trade surplus.

But since 2007, sterling has fallen by nearly 25 per cent on the trade-weighted measure, yet the trade deficit has remained stable at 2.5 per cent of GDP, while the current account deficit has alarmingly widened from 2.3 per cent to 3.7 per cent of GDP.

Kevin Daly of Goldman Sachs argues that this is due to high inflation in the UK. Currently consumer price index inflation stands at 2.8 per cent (which many analysts expect to nudge up further over the course of the year), and the retail price index measure is at 3.2 per cent. Higher inflation mitigates the UK’s competitive advantage gained by currency depreciation, and deters traders from holding sterling, since its purchasing power is eroding faster compared to other currencies (both euro area and US inflation are currently below 2 per cent).

Of course, the Eurozone crisis has not helped. Nearly half of the UK’s exports go to Europe, accounting for around 15 per cent of UK GDP. With no sign of the Eurozone springing out of its economic malaise, a recovery is unlikely to come from exports.

DON’T EXPECT THE RALLY TO LAST

Many are confident that the UK will avoid a dreaded triple-dip recession, but Samuel Tombs of Capital Economics is less optimistic, saying that even the positive service sector data “suggests that GDP did no better than flatline in the first-quarter, and a triple-dip recession remains a risk”.

More light will be shed on the UK’s economy today, when the latest trade and industrial production data are released. And Tombs thinks that both will have worsened. Expect this to weigh on the pound. And it may be just the catalyst for sterling to resume its journey lower.