Sterling’s outlook waiting on rates

Tuesday saw the usual flurry in forex markets when the latest UK inflation figures were released, showing annual CPI at a larger than widely expected 4.5 per cent.

The pound rallied half a cent against the US dollar in very short order and then over the course of the next few hours these gains were given back.

This is a regular dance at the moment. Although interest rate speculation causes the short-term excitement, there’s more to the fate of the pound that – which is why the next 12 months may see little in the way of change for sterling-dollar.

On the face of it, we have a more fragile recovery in the UK but are looking to tackle the debt problem – in the US, the recovery looks more secure but unemployment is a bigger problem, as is the level of US debt. It is difficult to see much change to this situation over the course of this year, and it would not be surprising if sterling-dollar ended the year roughly where it started this one – around $1.5500. That doesn’t mean there won’t be volatility along the way – forex is seldom dull and we could well see a run up to the $1.7000 level into the summer. But those heady levels have been too tempting to sellers of the pound in recent years, so it is difficult to be too ambitious for even higher targets, which is why short to medium term the outlook looks choppy, but long term broadly unchanged.

The pound has been range trading against the dollar between $1.7000 and $1.4000 since March 2009. It has been the wallflower of FX markets for so long that it is difficult to take a longer-term view. If you want to trade sterling you need to know two things: firstly, the direction of the dollar and secondly, the direction of the euro. When the euro is higher this tends to drag sterling-dollar up with it.

This is because of uncertainty around the outlook for the UK economy. Yesterday’s strong inflation reading for April didn’t give us the full picture because it was distorted by the late Easter/Royal Wedding super holiday, putting upward pressure on transport prices. While the market expects a rate hike by December, I am less sure. I think the Bank of England won’t be able to hike rates until headline prices fall and wages start to rise. That could be well into 2012, and that depends on commodity prices continuing to come off and the labour market starting to tighten.

This should leave the pound trapped in the same two-year-old range. In the near-term, the pound looks vulnerable below $1.6200, below $1.6125 it’s no longer in a technical uptrend, at this level we may see back to $1.6000 – the March 2011 low. Gains are likely to remain capped at $1.6500.

Yesterday it was announced that UK inflation for April pushed up to 4.5 per cent. To date the Bank of England (BoE) Monetary Policy Committee (MPC) have been reluctant to raise rates, given the fragility of the UK economy; yet with inflation running at more than double the BoE target rate, it is unlikely they can protect the consumer for much longer, and they have warned that an interest rate hike is likely at some stage, having a significant impact on sterling.

Since the outset of this year, sterling has proven to be very sensitive to interest rate expectations and over the past couple of months we have seen sterling weaken, as forecasts for the inevitable 25bps interest rate hike have been postponed to the latter stages of this year. However, a royal wedding in April has certainly given a boost to the consumer, with the British Retail Consortium reporting a surge in volumes on the high street of over 5 per cent in April, the strongest reading in five years. On top of this, a competitive sterling has seen exports grow, allowing the manufacturing sector to revitalise. The FX markets reflect a country’s prices in the international markets and with the strengthening euro we have seen the costs of German goods surge in price. If the UK can seize the opportunity to benefit from its lower prices by boosting sales rather than corporate profits, then sterling should start to reflect increased activity and push higher from its undervalued territory, especially against an over-valued euro.

The outlook for sterling is a very mixed one. On the one hand, you have a government that is attempting to rebalance the books by reining in government spending, if only to levels of a few years ago, but on the other hand, the headwinds being faced by the UK economy aren’t conducive to investors flooding back into sterling.

As the financial crisis unfolded back in 2007, the pound plummeted on the back of the UK’s huge reliance on the banking sector. The Bank of England responded by slashing interest rates to an all time low and were much more aggressive in their monetary policy than many other central banks, which further compounded the woes for sterling.

At one point it looked as though parity with the euro was very much on the cards, but since 2009 it seems the Great British pound reached a floor and now sentiment against isn’t so bearish. On the other hand, it isn’t so bullish either.

The problem for sterling is that inflation in the UK is way above target However, the Bank of England doesn’t want to raise rates in case it snuffs out the little growth prospects we have. Interest rates are likely to remain low for some time yet, and for as long as they do, the pound is unlikely to appreciate much.