Sterling, a Year of Living Dangerously

Sterling will have a tightrope to walk during 2012 as the UK is buffeted by Euro-zone and global developments. Vital UK currency support, gained from an exodus of funds from the Euro area and interest by reserve managers, will be severely tested in the new year. The government’s economic strategy is hanging by a thread with very little room for manoeuvre on fiscal policy and the UK is at the mercy of global events. Only a further small-scale shock would leave the economy in serious danger which would also weaken Sterling. Without capital controls, the inward flow of funds could turn into a debilitating exodus. Currency levels, however, are all about relative performance and, with all major currency areas facing severe structural challenges, Sterling should be able to avoid severe damage.

The most likely outcome is that Sterling will weaken against the dollar with a slide to below 1.50 and potentially a move to the 1.45 area during the first half of 2012. If the Euro area remains intact, Sterling has the potential to advance to the 0.7850 area. If the Euro area splits, then Sterling will weaken very sharply towards parity against a new hard Euro.

There is no doubt that the economy deteriorated during the last few months of 2011. The actual survey and economic evidence was actually mixed and generally held up better than expected which offers some hope for the year ahead. What was striking was the degree of pessimism by the Bank of England. Their unease, bordering on fear, will certainly increase recession fears, although the over-riding factor is the uncertainty.
The UK fixed-income market had a remarkable run over the second half of 2011, culminating in benchmark 10-year yields falling to record lows of 2.00% as defensive flows poured into Sterling. Inflation will fall early in 2012 which will help underpin confidence. Given the UK and international debt profiles, the aggressive fiscal tightening will put the UK in a very strong position if there is sufficient global growth to allow the UK safe passage through the tightening phase. Currency independence will also prevent Sterling being trapped in the Euro area deflationary spiral.

There is, however, now a much higher risk that international conditions will conspire against the UK. The government has already had to raise its borrowing forecasts by £100bn over the next five years even before any second recession. The banking sector faces renewed stresses and any further bailout requirement would have a devastating impact on public finances.

Bond yields look to be very close to a one-way bet as it is very difficult to see them falling significantly further even with inflation falling. In this context, it will be much more difficult to attract overseas funds on valuation grounds.

If fears surrounding the Euro-zone economy increase then the UK outlook will continue to deteriorate. The UK has been broadly insulated from sovereign debt fears during 2011, but talk of credit-rating downgrades will intensify if the UK enters recession and it won’t just be the Bank of France calling for a downgrade to the AAA rating. A vicious cycle of capital outflows and weakening growth could expose Sterling to heavy selling.