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Thursday August 25, 2005 - 14:15:11 GMT

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Sterling at risk from debt levels

The UK economy is liable to suffer an extended period of below-par growth as the housing-market excesses will need to be worked out. The burden of high debt levels will undermine consumer spending growth with the manufacturing sector likely to remain weak. There is scope for a further cut in interest rates early in 2006, but the Bank of England will find it difficult to provide significant monetary stimulus if inflation stays above target. In this context, stagflation fears for the economy are liable to increase in the short term.

With confidence in the US economy still broadly intact and markets looking for further US interest rate increases, Sterling will struggle to make significant headway against the US currency in the short term. There is also a risk that Sterling interest rates will not be seen as high enough to attract funds on yield grounds while growth concerns will weaken its defensive credentials. Overall, there will be the risk of a gradual erosion of Sterling support over the next 1-2 months, especially as international funds are liable to withdraw funds, although high oil prices will offer some near-term support.

During the fourth quarter, US economic doubts are liable to return and this should offer important support to Sterling against the US currency. Overall, a UK recession would probably be needed to justify sustained Sterling weakness below the 1.70 level against the dollar on a six-month view.

Sterling hits resistance

Sterling has recovered strongly from lows below 1.73 against the dollar seen in July, but has been unable to maintain levels above 1.8100 against the US currency. Sterling also strengthened to highs of 0.6770 against the Euro from lows beyond 0.70 in July before weakening back through the 0.68 level.

The latest economic data has continued to suggest slowing GDP growth. Headline retail sales, for example, fell 0.6% in July reversing the gains seen in June. The underlying data is more important given monthly volatility and the core sales growth in the 12 months to July was 0.4% compared with growth of 7.9% seen the previous year. Underlying consumer demand is likely to remain weaker in the short term. Although confidence levels have held relatively firm, there will be greater caution due to the impact of high debt levels.

The August interest rate cut to 4.5% may stabilise confidence in the housing sector, but there is unlikely to be a substantial recovery in spending growth rates, especially given the historically very high debt burdens in relation to income. High energy prices will also undermine consumer spending levels. The latest CBI industrial sector report recorded a further deterioration in orders and the sector is liable to stay near or in recession over the next few months. Government spending will not be able to provide an additional boost and the economy will find it difficult to find growth leadership.

Complications for Bank of England

On growth considerations, there are likely to be pressures for further cuts in interest rates to help support spending and the manufacturing sector, although the evidence suggests that there is no urgent need for a further short-term rate cut.

The headline annual consumer inflation rate increased by more than expected to 2.3% in July from 2.0% and producer prices have risen strongly with annual growth rates for input prices running at over 10.0% due to the impact of high energy costs. The Monetary Policy Committee will inevitably be cautious over cutting rates while there are elevated inflation concerns, especially with the headline rate above the 2.0% target rate. Expectations of a further cut in rates have also been dampened by the August Bank of England minutes. There was a narrow 5-4 vote in favour of the cut with the central bank governor King among the four who voted against the reduction. In the short term, there is likely to be strong resistance to further rate cuts from the Governor and there will need to be compelling evidence of further economic deterioration to gain majority support for another rate reduction.

There is the potential for a further small reduction in rates early in 2006 assuming that there is a moderation in energy costs.

Yield support will still weaken

Sterling’s yield advantage relative to the US currency will still tend to narrow in the short term as the US Federal Reserve pushes interest rates higher. The Fed looks certain to increase rates in September and will look for further a further increase in November. It is also a possibility that UK rates will fall to below US rates in the first half of 2006. From late 2005, however, there will be growing risks of a pause in the US tightening and this should offer Sterling support. The UK currency will also secure protection from the underlying US structural weaknesses, primarily the substantial current account deficit.

High energy prices will offer some Sterling support on trade grounds in the short term. Nevertheless, there will be a growing risk that Sterling will be unable to find a strong case for international capital inflows. Interest rates will not be high enough to attract funds in search of high yields, especially in view of the slowdown in growth and rising US rates. The yield spreads on UK bonds over US Treasuries, for example, has weakened to around 5 basis points. Sterling is also unlikely to be seen as an attractive destination on defensive grounds given the underlying economic doubts.

Housing sector will be vital

The UK housing sector will be very important for underlying Sterling trends and there has been evidence of some stabilisation in the sector over the past few weeks, although transaction levels are still considerably lower than last year. The overall evidence suggests that there will need to be a further reduction in prices over the next year given the extent to which prices are above their longer-term equilibrium level.

The pattern of any price falls will be very important for the currency. The most likely outcome is that prices will grind slowly lower as sellers will only be willing to drop prices when the economic pressures increase and levels of distress selling increase. If this is the pattern, there is likely to be an extended period of disappointing GDP growth in the economy, especially if unemployment edged higher. In this environment, Sterling would also be exposed to a gradual loss of support, but a destabilising and severe loss of confidence should be avoided.

If housing prices stay at current levels or rise, there will be the potential for short-term Sterling support, although the longer-term implications would probably be negative for the currency as it would be likely to postpone rather than prevent medium-term price declines.

The less benign scenario for Sterling would be a sharp drop in prices as this would substantially increase the risk of recession in the economy. The overall dynamics of interest rates and underlying economic trends suggests that this should be avoided, but the risks should certainly not be discounted.


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