Sterling falls to six-month low on grim outlook for UK economy

STERLING is once again the whipping boy of the forex markets. It fell to a six-month low against the euro on Monday after a report from the Centre for Economics and Business Research (CEBR) suggesting that sterling could hit parity versus the single currency. <br /><br />And despite relatively healthy retail sales and house price data, inflation fell faster than expected in September to its lowest rate for five years. This put renewed pressure on sterling, which continued to fall against the euro and to a five-month low against the dollar. Only some bullish comments from Charles Bean, deputy governor of the Bank of England, stemmed losses in the currency.<br /><br />The past few months have proved difficult for sterling. On a nominal trade-weighted basis the sterling index is down by 8 per cent since the end of June, while it has fallen 9 per cent against the euro.<br /><br />Furthermore, there is potential in the UK for further quantitative easing at a time when many advanced economies are starting to tighten or think about tightening monetary policy. <br /><br />This expansion in UKeasing comes against a backdrop of a weak recovery and with uncertain fiscal policies unnerving investors. With prime minister Gordon Brown offering little in the way of longer-term plans for fiscal sustainability, it is difficult to see how sterling will recover from this, say Foreign Currency Direct market analysts. <br /><br />So with sterling on a seemingly unshakeable downward trajectory, how low can it go against the other major currencies and is it expected to stay at these weak levels? Well, the CEBR was certainly fairly pessimistic about the prospects for the UK currency. It sees interest rates possibly staying at the record low of 0.5 per cent until 2011 and reach only 2 per cent by 2014, which will reduce the attractiveness of the pound.<br /><br />It said that the forex markets will want to pump down the value of sterling if they see an extended period of low rates and that there is at least a one in three chance that sterling will fall below parity with the euro in the near future.<br /><br />A number of currency strategists are also predicting parity, some as early as the end of October. Duncan Higgins, senior analyst at currency provider Caxton FX, says: &ldquo;Outside of slight profit taking, we are unlikely to see the pound find much support over the short term, and it is now on course to fall to parity with the single currency, particularly as the Eurozone continues to emit positive signs.&rdquo;<br /><br />Equally concerning is sterling&rsquo;s current unresponsiveness to risk appetite &ndash; typicall when risk appetite rises so does the pound. For much of the economic crisis, sterling has been seen as a barometer of risk appetite. But recently, it has failed to respond strongly to intra-day upward moves in investors&rsquo; taste for risk. Stephen Gallo from Schneider FX says that this is unnerving and that currency traders are now focusing more on the fundamentals, which will not be good news for sterling.<br /><br />Against the dollar, Gallo thinks that sterling is fairly priced in the $1.55-$1.65 range as US fundamentals are not strong enough to justify a sub-$1.55 level. But speculative positions in the pound at the end of September were the largest net-short since February, so there is definitely some appetite among currency traders to see the pound move lower. <br /><br />However, it has been argued recently that the UK, due to its weakness and the still suffering banking sector, would have to repatriate funds, leading to sterling strength later this year. UK banks will have to boost their equity base by about $120bn to conform to the Basel II standard, an amount which is much greater than the requirements of the US or Eurozone, relative to the size of the underlying economy. This would ultimately prove bullish for sterling as banks would need to hold more sterling-denominated assets.<br /><br />But BNP Paribas currency strategists say that if you look at the UK&rsquo;s asset holdings abroad, there is little to dispel a bearish outlook on sterling. Bank loan-related foreign assets tend to be currency-hedged or funded in the currency in which the loan is raised. Such repatriation by UK banks should have no currency impact.<br /><br />What matters for sterling are in fact changes with portfolio and foreign direct investment (FDI)-related assets as these are not entirely hedged. And given the UK&rsquo;s poor macro outlook and its soon-to-be high and uncompetitive tax regime, BNP Paribas expects FDI flows to reverse. This can only mean one thing for sterling &ndash; outflows will see the pound weaken further.<br /><br />Despite improving economic data, the prospects for the UK are looking decidedly grim. Investors will not want to invest in an uncertain and risky country and it will take a complete shift in both monetary and fiscal policy to put the UK, and sterling, back on an attractive footing.