Financial markets in the past week have had to contend with two UK-borne shocks: The ruling Conservative party’s loss of a majority in last Thursday’s general election and three MPC members voting in favour of a 25bp hike at today’s Bank of England policy meeting.
Sterling, which sold off sharply after the election result, has recovered this week and the more hawkish than expected MPC meeting has given the modest rally further impetus.
Confirmation of an alliance between the Conservatives and DUP, which is expected in coming days, may see Sterling strengthen further, particularly with markets digesting the implications of two further MPC members calling for higher rates.
This would, in my view, present an opportunity to short Sterling versus the dollar or euro, for five reasons:
- Conservative-DUP marriage is not one of choice and arguably not even one of convenience;
- Question of which type of Brexit is unlikely to be answered any time soon;
- MPC has become more hawkish but rate hike still unlikely near-term;
- Concerns over falling wages are at the heart of a UK economy which remains at best soft; and
- EU/eurozone growth slowly picking up and European nationalism on the back foot
There are multiple factors behind Sterling’s collapse in the past fortnight to decade lows and the question remains whether these factors will reverse any time soon.
At the top of the pyramid of causes for Sterling’s demise, in my view, is not the UK’s large current account deficit or Bank of England (BoE) policy but the stance on EU membership which Prime Minister Theresa May has adopted.
So while Sterling’s greater competitiveness may eventually drive FX inflows into the UK and help Sterling to recover, financial markets and investors are likely to continue to take their cue from the British government near-term.
Simply put, if Theresa May continues down of the path of “Hard Brexit”, however ill-defined, Sterling is likely to remain under pressure.
However, history shows that while EU leaders have a tendency to drag their feet over key issues, they are able and willing to eventually find some kind of compromise.
Moreover, Theresa May will be subject to the will of her own Conservative Party – which on the whole supports membership of the UK or at least a softer form of exit from the EU – and of the people.
While the BoE would prefer a more stable currency and lower yields, there is probably little than it can (or should) do near-term beyond trying to reassure markets, investors and households. Read more