Sterling – is the good news in?

The next few months up to the UK election offer significant downside risks for GBP, especially against the EUR and JPY.

Sterling has benefitted over the last couple of years from the UK’s relatively strong growth performance even though this has yet to deliver a rate hike or even a real near term expectation of one. To be honest, I think the Bank should have hiked rates already – the excuse that inflation is currently low doesn’t really wash, as on the 2-3 year horizon the current weakness of inflation will lead to higher inflation assuming the oil price stabilises or rises from here. Stronger demand due to the current low oil price will help boost growth, wages and inflation going forward, and should provide a good case for higher rates after the election.

But while I think the Bank should have raised rates already, the fact is they haven’t, and are very unlikely to move this side of the election. So until after the election, most of the good news does seem to be in, and abstracting from the run up to the Scotland referendum, there may be some severe electoral downside risks that could take hold quite quickly even if the risks appear to be well known.

The polls are unclear, but a Labour/SNP coalition certainly looks a very possible outcome. I suspect this is not something the market would greet with open arms. The concern is that a focus on taxation of the wealthy could undermine capital inflows into the UK, and even if this were only temporary, it’s a dangerous prospect for the  country with the biggest current account deficit (as % of GDP) of all the majors.

Now, the pound is very strong against the EUR and the JPY, so these are the currencies against which it may be most vulnerable. The EUR in particular is at levels which are equivalent to sub-0.70 pre-crisis in real terms given the high UK inflation rates in the meantime. The risk premium in the EUR certainly looks justified given the Greek uncertainties, but may diminish on a temporary deal and both the Eurozone and Japanese economies will benefit even more from the decline in the oil price than the UK.

It may well be that UK rates do rise earlier than the market currently expects, in which case there may be a sterling buying opportunity after the election. The trouble is that the factors that make sterling attractive are also the seeds of its destruction, because relatively strong UK growth has created the big current account deficit. This may not prevent another sterling rally, but I think it will have to come from lower levels. Right now, the risks are on the downside, and I like selling GBP/JPY to avoid too much commitment to the Eurozone recovery story. Look for a dip sub-170, with 188 a good stop area.

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