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FX Briefing - Pound Sterling: out of favour

FX Briefing 18 April 2008

Highlights

·        Problems in housing market and financial sector jeopardise UK economy

·        BoE could have more scope for bigger interest rate cuts in the second half of the year

·        As long as ECB remains hawkish, EUR-GBP at risk of depreciating

Pound Sterling: out of favour
For almost five years, from the beginning of 2003 until autumn 2007, EUR-GBP remained very stable at around 0.68. But the close correlation between euro and pound came to an abrupt end in September 2007 in the wake of the credit crisis.

This was actually triggered by the collapse of mortgage lender Northern Rock and the Bank of
England’s sudden U-turn: only a few days after central bank governor Mervyn King had told
parliament that he was against bailing banks out, the BoE was forced to mount a rescue operation for Northern Rock. Since then, the
UK currency has lost more than 15% against the euro and is now around £0.80 – a level last seen in autumn 1996.

The pound’s weakness is largely due to the fact that the UK economy is far more vulnerable to the risks arising from the credit crisis than the eurozone. There are two main reasons for this:

1. UK growth is heavily reliant on the financial services industry, more so than that of other
countries. According to Eurostat, in the
UK “business activities and financial services”
have a 34% share in real value-added, compared with 28% in the eurozone. Furthermore, this sector has contributed most to growth over the last few years: from 2002 to 2007, total real value-added rose by 15% in the
UK; that of corporate and financial services sector went up 26%.

Now, in the wake of the financial market crisis, growth appears to be slowing down. Economic
indicators for business activities in the services sector, including the purchasing managers’ index and the index of services, are showing a significant loss in momentum. Reports of poor business, surplus capacity and restructuring in many financial companies are confirming the unfavourable impression.

2. Another sector with above-average growth was the building sector. Soaring property prices, low financing costs and a high proportion of borrowing led to a long-lasting building boom. Now, however, house prices have stopped rising, and financing conditions are deteriorating. The limited refinancing possibilities and high costs are being passed on directly to borrowers.

Bank lending data are indicating a dramatic development: in February, the number of mortgage loans approved fell by almost 40% compared with February 2007, and the volume of securitized mortgage loans was down 26%. The latest Credit Conditions Survey shows that risk premiums are tending to be higher and credit availability more restricted, particularly on securitized loans to households. Banks are also registering an increase in credit defaults.

Thus the crisis will slow down UK economic growth markedly. Admittedly, retail sales for the first quarter are still indicating a robust increase in private consumption. But wage growth seems to be slowing, and energy and food prices are pushing consumer prices up. Furthermore, consumer confidence has plummeted to its lowest level since the early 1990s.

The International Monetary Fund is therefore expecting UK economic growth to halve from
3.1% in 2007 to about 1.6% in 2008 and 2009. Because of a statistical effect, however, the quarterly growth rates are only around 0.25% in 2008, which is well below trend growth. This, together with the problems in the financial sector and the housing market, should give the Bank of England a good reason to cut interest rates further. In summer, at the latest, by which time inflation will have peaked, there should be scope for more substantial monetary easing.

Given the fact that the UK economy is particularly at risk, compared with the rest of the EU, we see the pound remaining under pressure for some time to come: despite the fact that the euro has already appreciated significantly, we are not ruling out a further increase against the pound to about £0.85 in the next few months. At the latest, the exchange rate will stabilize when the ECB starts opening the door for interest rate cuts too.

Stephan Rieke +49 69 718-4114

Economics Department
+49 69 718-3642
volkswirtschaft@bhf-bank.com
Foreign Exchange Trading
devisenhandel@bhf-bank.com
Jörg Isselmann
+49 69 718-2695
Matthias Grabbe / Klaus Näfken
+49 69 718-2688

 

<i>This report has been prepared by BHF-BANK Aktiengesellschaft on behalf of itself and its affiliated companies (together "BHF-BANK Group") solely for the information of its clients. The information and opinions in this document are based on sources believed to be reliable and acting in good faith, but no representation or warranty, express or implied, is made by any member of the BHF-BANK Group as to their accuracy, completeness or correctness. Opinions and recommendations are given in good faith but without legal responsibility and are subject to change without notice. The information does not constitute advice or personal recommendation, for which the duty of suitability would be owed, but may facilitate your own investment decision. Moreover, you should seek your own advice as to the suitability of an investment matter mentioned herein. Investors are reminded that the price of securities and the income from them can go down as well as up and that the past performance of an investment or a market is not necessarily indicative for future results. This document is for information purposes only. Descriptions of any company or companies or their securities mentioned herein are not intended to be complete, and this document is not, and should not be construed as, an offer to sell or solicitation of any offer to buy the securities mentioned in it. BHF-BANK Group and its officers and employees may have a long or short position or engage in transactions in any of the securities mentioned in this document, or in any related securities. This publication must not be distributed in the United States.

© 2007 BHF-BANK Aktiengesellschaft

All rights reserved. Please mention source when quoting from it.

 

 

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