In a ‘truly alarming’ sign, soaring UK yields fail to save the pound

The pound simply cannot take a breather as the bleak economic outlook for the UK overshadows any benefit the currency might derive from rapidly rising interest rates.

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(Bloomberg) —

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The pound simply cannot take a breather as the bleak economic outlook for the UK overshadows any benefit the currency might derive from rapidly rising interest rates.

Another record inflation reading this week has money market traders betting that the Bank of England will more than double its key rate to 3.75% by March, from 1.75% currently.

Rather than buying sterling, investors sold it, while options traders remained steadfastly bearish on the currency against the US dollar. They have also piled into hedges against rising consumer prices, betting that the worst is yet to come.

In theory, rising rates should act as a tailwind for currencies and a headwind for bonds. But in the UK, poor growth prospects, price pressures and uncertainty about the policy trajectory under a new leader are weighing on both demand for pounds and bonds. The pound has fallen against the euro and the dollar so far this month, even as rising UK bond yields outpace other markets.

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“If this trend continues, it could be really alarming,” said Mike Riddell, portfolio manager at Allianz Global Investors. Global investors “probably don’t like the UK’s double-digit inflation combined with the incendiary prospect of the likely next prime minister launching fiscal stimulus,” he said.

It’s a dynamic that Adam Cole, currency strategist at RBC Capital Markets, has also spotted. This kind of break in the correlation between currency swings and yields is typically associated with emerging market currencies, suggesting investors are questioning the credibility of British politics, he said.

Cable was trading around $1.18 on Friday, on track for its worst weekly performance since September 2020. The Fear and Greed indicator, a momentum indicator that compares buying to the strength of sale, implies that sellers control prices again. The British currency also fell to its lowest level against the euro in almost a month.

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Part of the problem is that the UK’s cost of living crisis may limit the extent to which the BOE can rise despite soaring inflation. Protests and strikes are already widespread as workers demand higher wages.

One-year inflation swaps, which indicate traders’ bets on the level of the retail price index over the next year, rose above 11.5% after jumping 295 basis points since the Tuesday’s close, ahead of July inflation. Trading volumes also surged: one- and two-year gross notional volumes were around six and nine times higher than usual, respectively, according to data compiled by Barclays Plc.

Data released on Friday showed British consumer confidence fell to the lowest since records began with a near-early 1990s recession looming. Meanwhile, government borrowing was higher than expected in the first four months of the fiscal year after the cost of debt soared, raising questions about tax cuts promised by the two presidential candidates of Prime Minister.

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Not enough

These high price pressures also mean that real UK policy rates could remain negative, according to Bank of America strategists.

Their calculations, based on market prices and their own inflation forecasts, showed that the UK will have the most deeply negative real terminal rate of any G-10 country. The euro zone is in a similar position.

“The ECB and BOE have the most negative real rates and may need to do more, but it’s not certain they will,” BofA strategists wrote. “In practice, we believe the ECB and BOE may not be doing enough, which would be negative for their currencies.” They recommend buying the euro-sterling volatility.

Looking further ahead, some analysts are also starting to reassess the currency’s valuation in light of the UK’s large deficits. RBC considers it “highly likely” that the UK current account deficit will stabilize around 6-7% of GDP.

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“The further we look, the more confident we are that a weaker exchange rate will play a key role in keeping Britain’s deficits funded,” RBC’s Cole wrote in a note, as a falling currency boosts the performance of UK equities and reduces the relative price of UK assets.

There are a few glimmers.

HSBC Bank Plc is signaling signs that the weakening business cycle may start to put less upward pressure on prices. The Confederation of British Industry’s expected selling price measure fell to its lowest since September 2021, for example, a good leading indicator of inflation in the past.

Still, the balance of risk remains on the downside for the pound, said Dominic Bunning, senior FX strategist at HSBC. The bank has a forecast of $1.16 for the first quarter of 2023.

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The flight to safe-haven assets such as the dollar has been one of the biggest influences on cable moves this year, according to HSBC. Although the impact on rates has jumped, the outlook remains gloomy as the stronger economic situation in the US could allow the Fed to rise more than the BOE.

“If the rate story dominates, the dollar will do better,” Bunning said. “But if risk appetite dominates, the pound will underperform anyway.”

Next week

  • Bond investors will be looking for further clues to the ECB’s thinking, with minutes of their latest monetary policy decision in July due out on Thursday
  • Flash PMI data for the UK and Eurozone will also give further insight into how economies are doing under the weight of rising energy prices, while Thursday will also see the survey’s release. German Ifo
  • Eurozone sovereign supply is expected to total around nine billion euros next week, according to strategists at Commerzbank AG. Auctions are planned in Germany, Belgium and Italy, while Finland could start its syndication season with a new five-year benchmark, they wrote in a note to clients.

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