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Forex Blog - Economics Weekly - How low can sterling go? Weekly economic data preview - BoE & Fed minutes due as expectations of further rate cuts rise

Economics Weekly 17 November 2008


How low can sterling go?

The pound has been falling sharply in the past year...

Sterling has fallen sharply in the past year, down by 20% on the trade-weighted index. The fall against the dollar and the euro has been as deep or deeper, with depreciation of 29% and 16%, respectively. What is going on and how low can sterling go against the dollar and the euro, and what would be the implication for price inflation and hence for monetary policy? In the past, sterling declines of this order would lead to rising price inflation (see chart a) and a subsequent rise in interest rates that would weaken the economy and so help to keep inflation in check, but the Bank of England's view is that inflation will remain low this time. The reasons are that the economy is in recession, making it very difficult for price rises to be passed on by firms (though this may mean profits fall and so unemployment ends up being higher), commodity prices are now falling after rising to record highs in mid 2008 and, crucially, wage inflation is receding, as unemployment rises and employment prospects dim. the inflows from overseas required to fund the trade deficit slows...

The UK runs a trade and current account deficit, which means that inflows of capital from abroad are required to balance its external accounts. But with short and long term interest rates having fallen and the issuance of gilts likely to rise quite sharply, as the UK government spends and borrows more to help offset the recession, the returns for foreign investors have fallen. Hence, they are not purchasing as much UK gilts and bonds and so the exchange rate has fallen, partly in order to make these assets cheaper in foreign currency terms and therefore more attractive to buy. Moreover, with the prospect of further interest rate cuts and increased government spending ahead, the currency is adjusting lower in anticipation of this becoming reality. So, given these trends, how much further can the pound fall against the US dollar and the euro? We focus on these currencies because together they account for nearly 70% of UK exports and imports, and therefore largely determine the path the trade-weighted index (TWI) takes going forward.


...and this is happening because a range of factors that determine its long run value have moved against it...

We have identified six key variables that are critical to the long run direction of the Trade Weighted Index (TWI): short term interest rate differences, long term interest rate differences, inflation differences, and differences in productivity, current account positions and budget deficits. There are, of course, other factors that affect a currency's value, such as the political climate, the willingness to accept foreign investment and investment flows. However, these are difficult to model or show a relationship that can be depicted clearly in statistical estimates.


Looking at the six key variables that compare the UK economy against the US and the euro area shows that almost all have deteriorated in the last two years. Where they have not, there is little or no improvement in the UK’s relative performance, leaving a fall in sterling the most likely outcome from where it started two years ago, which in any event was a high level historically. In terms of current account deficits, the UK position has worsened versus the US and euro area in the last two years, and quite sharply versus the latter. For the fiscal position, although the UK’s position has improved against the US in the last few years, it has worsened against the euro zone, meaning a fall is more likely in sterling versus the euro than sterling versus the US dollar on this basis.


In terms of price inflation, the UK has performed well in the last decade as a whole but in the last two years its inflation rate has risen relative to the US and euro area, though more so against the latter than the former, implying a lower pound. For productivity gains, the UK performance has been good against both economic areas but in the last two years it has also slipped back quite sharply, see chart b. In terms of short term and long term interest rates, the overall implication is that the exchange rate could fall further. Although there has been some volatility, charts c and d show that, particularly versus the euro, the fall in the pound is fully justified. The UK’s usual interest rate premium against the euro has eroded, and what this implies in terms of a weaker currency is most vividly illustrated in chart e. Hence, the recent fall to record lows in sterling versus the euro should be no surprise, and indeed, if UK short term interest rates fall further relative to euro rates, then there could be fresh lows for the pound against the euro before too long.


...and these variables suggest that further falls are likely as UK interest rates are cut aggressively

Pulling all of these factors together in one indicator, see chart f, shows that after being in overvalued territory in the five years to mid 2007, the fall in the UK TWI has taken it back almost to where a composite index of the six key drivers of its value would suggest. Indeed, on this basis, the recent depreciation of sterling may be overdone, but if the expectations about the extent to which the MPC may cut interest rates and the budget deficit may widen are proved correct, then the recent market move is simply anticipating these shifts. However, if interest rates are cut more than expected, or price inflation does not fall back as projected in 2009, the pound could fall even further. On our calculations, the UK trade-weighted index could easily drop an additional 10 to 15%. Whatever the outcome, the foreign exchange markets seem to be showing that sterling is in for a bumpy ride in the year ahead.


Trevor Williams, Chief Economist, Corporate Markets


Weekly economic data preview W/c 17 November 2008

BoE & Fed minutes due as expectations of further rate cuts rise

The minutes of the BoE and the US Fed's last interest rate setting meetings are published on Wednesday. Both are likely to show strong support for the last round of interest rate cuts, given the worsening global economic backdrop and the growing possibility that inflation may drop sharply, undershooting targets. Last week's BoE November quarterly inflation report showed a significant downward revision to the UK inflation outlook, predicated on lower commodity prices and weak domestic demand. The BoE now seems to take the view that the economy will join the eurozone in technical recession this year, as it emphasised the likelihood of another contraction in Q4 and a 1.5% decline next year before recovery in 2010. Although the last 1.5 percentage point interest rate cut and the heightened possibility of another one percentage point cut to 2% in by the end of the year should deliver a strong economic stimulus, continuing problems in inter-bank and credit markets and job insecurity and unemployment rising mean a more prolonged recession may now be likely, even with coordinated fiscal initiatives. In the Eurozone, the initial Q3 GDP result showed a 0.2% contraction. EU-15 data this week may show a very weak set of manufacturing & service sector surveys for November, increasing the possibility of another output contraction in Q4. Recession in the major economies will trigger a sharp drop in consumer inflation, which gives justification for further interest rate cuts. The BoJ is expected to keep interest rates on hold at 0.3% at its meeting on Friday, having made its first cut in seven years last month.


The BoE minutes from the 5/6 November MPC meeting due on Wednesday are likely to show unanimous support for the large cut in rates and a very bearish discussion on growth and inflation. In some ways, the minutes have been superseded by last week' quarterly inflation report, but the details of discussions will still attract considerable interest. UK data this week include CPI inflation, which could fall to 4.7% in October from 5.2% in September. This will mark the start of a sharp downward trend as lower food & energy prices and weak high street sales dampen the index. The UK also publishes retail sales data for October - anecdotal reports suggest that monthly sales may fall by 1%, bringing the annual rate to 1.3%, close to the low of 0.6% annual growth in September 2005. Public finance data may show the PSNB YTD cumulative balance rising further from £37.6bn in September, the highest 6-month shortfall since 1946-7 and up from £21.5bn a year earlier. Clearly not a good place from which to embark on emergency fiscal spending. However, extraordinary measures will be enacted on 24th November (publication of the Pre-Budget Report) to boost the economy.


• There may be no surprises in the minutes of the Fed's 28/29 October FOMC meeting - the discussion is likely to have focused on downside risks to growth, keeping open the possibility of another cut in official interest rates by year-end. US data releases are likely to show that producer and consumer prices decreased in October, following reductions in key commodity prices. Capacity utilisation is also important as it could fall close to the 75% level which may indicate that the recent acceleration in jobs losses could be stepped up. Clearly, should job insecurity continue to contribute to weak consumer spending, the government's task of getting the US economy moving again will become an even more difficult one. Both the Empire Manufacturing and the Philadelphia Fed surveys for November are expected to show a worsening business outlook. Neither is the housing market situation improving as housing starts and building permits are expected to have decreased in October.


• This is a quiet week for eurozone data as initial Q3 GDP and final October CPI inflation were published last week. The PMI manufacturing and services surveys for November are due, however, and could come in below the October lows of 41.1 and 45.8, respectively. Given the disparity in Q3 GDP results between member countries, the PMI regional breakdown will provide some indication of whether German PMIs also under-perform the EU-15 average.

Nichola James, Senior Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.





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