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Monday, January 21, 2013

Will the pound really take a beating from the UK's debate on Europe?

Ahead of David Cameron's incredibly hyped speech, a bit of a foreign exchange side-debate has developed with some analysts suggesting that sterling could weaken significantly as talk of the UK leaving the EU increases uncertainty, while the eurozone starts to recover. Are such fears valid?

·         As we have pointed out repeatedly in recent days, the debate is not yet about a straight in or out - but whether the UK should seek new EU membership terms.Unfortunately, currency markets (notoriously volatile) may not capture that, even if businesses do.

·         In our view, if you're a currency analyst, there are more important issues that could drive sterling lower than the intensified EU debate, including the threat of a triple-dip recession, loss of the UK’s triple-A rating, continuing to miss debt and deficit targets and the election campaign in 2014/2015. Ultimately, we’d expect currency markets to take the lead from the UK’s wider economic policy than just the UK-EU issue.

·         As we discussed in detail in our outlook for2013, there is still a lot of uncertainty in the eurozone, particularly with the Italian elections and the fact that the structural flaws have not been solved. The ECB is also still providing copies amounts of liquidity with a very loose monetary policy. Although, the latter has helped strengthen the euro at times, we think there is a limit to how far this can go. During the crisis, the repatriation of assets from abroad by banks and firms in the eurozone has propped up the currency, as the situation improves slightly this may slow. These factors combined could cap any substantial strengthening of the euro.  

·         Although sterling has weakened in recent days, other indicators of safe haven flows, such as UK borrowing costs and the London property market, have continued to suggest that there is still very strong demand for UK assets.

·         Given that safe haven flows have continued for some time, sterling may be inflated above where it normally would have settled, as such any change may simply be a correction to the norm as markets turn more positive.

·         Currency strength is significantly determined by central bank action these days. With the US Fed planning to keep policy loose for the foreseeable future (and keen to have a weak dollar) and the ECB of the same mind-set, sterling may continue to be seen as an attractive option. The Swiss National Bank will also have to unwind its massive foreign currency reserves at some point, given that a significant amount of this is in euro it could weaken the currency.

·         In terms of impact on the UK, a weaker pound could aid the UK in terms of boosting exports. However, given our reliance on imports and the fact that a weaker currency could also see an increase in borrowing costs for the UK a decrease in foreign demand for our assets, the overall impact may not be positive. Sterling has devalued significantly since the start of the financial crisis with the boost to exports being minimal.

There is a good chance that sterling could weaken this year, which may not be good for the UK economy. However, the impact of a potential EU referendum in 2-3 years’ time on the currency should not be overstated. There are plenty of other more pertinent arguments to focus on both for the UK-EU debate and the analysis of sterling.


Rik said...

Markets are in tulip-mode. Short term vision on things and it is having problems with complicated issues with a political dimension (like the Euro-crisis are simply (even after more than 2 year) still very poorly analysed).

There is real fear that the UK will leave from one day to the other. Cameron can probably tackle that by a proper communication strategy.
Simply make clear that whatever happens there will a common market or something similar.

Another point but likely to come up in periods of a lot of stress. It is simply not clear that medium/longer term Cameron's strategy is more like damage limitation than doing damage himself.

The situation with the UK under the present conditions staying in the EU is simply unsustainable. Something has to happen. However markets only react on news and for 3-6 months or so so anything more longer term is off the radar. Look at the EZ hardly anybody with a brain would think that is stabilised. Still markets react like that has happened as they simply via newsflashes only react to the near future. No news good news as far as the Euro goes.
Here a longer term strategy probably will be necessary and often repeated.
Solutions where clearly never anybody in Germany would agree with were and are discussed as real options for the Euro crisis. A over-simplified idea of reality. Governments decide and what voters want is irrelevant. Well that doesnot sound like this situation here. But it is what many financial analyst still believe.
In general they have less ideas about the political situation than most people you meet in a pub.
Any British government will have to face the UK-EU relation music somewhere in the next couple of years. Cameron mainly tries to manage it.

Looks like the 2 things will have to be brought over in a simple way and in combination.
No exit of common market from one day to the next and anyway the situation needed change.

This is a new issue for the markets. They look from big (unmovable) to small (the UK). If there were proper analysis we would also see what it would do to Europe. Which is equally as bad. The UK is simply the most important trade partner for the rest of the EU and things falling apart will say it mildly hardly be benificial for the Euro rescue.

Better not wait that long. Markets possibly will not like but they would not have liked UKIP hitting 20% of the vote either and it was one or the other.
It is simply the first moment markets realise that there is something going one. Which rises uncertainty so markets donot like it. But as said political uncertainty, because UKIP would be put on the map they would have disliked considerably more. Here the fall out can be much better managed.

What will be helpful is not having important points of his vision move all over the place. Get the most important things out of it. Simplify them and stick to them (a big problem now) and repeat them as often as possible. He will have to do that towards the electorate anyway.
And act fast.

There is likley some collision between markets and electorate. The UK electorate probably has to be reminded as much as possble that it is complicated but that Dave is working hard on it. Markets would probably rather have no news. As said no news is at the moment seen as good news.

Rik said...

This all is a clear indication that both sides of the table will be best served by a swift and as low profile as possible solution on this issue.
When you have news you generate market reaction (for financial investors).
When you have uncertainty (aka hings not cleared up) on important issues especially in a difficult time real investors postpone investments.

This will somewhere further on up the road work in the same way for the EU. If the UK cannot sell in the EU it would also mean that it is the other way around. Especially for the very weak EZ economy this is likely to be seen as a considerable negative.
Not to mention how markets will look at a UK exit in relation to the events in the EZ. Will markets see it as things falling apart. Well my view is simple you better not try to find out. If they will (which is a real possibility with the over simplified vision most analysts have of Europe, at least for the first period) no ECB will be able to save it.
This will come up. The UK is the largest trade partner for the remainder of the EU (in case of an exit). Now the focus is on the big EU and the relatively small UK.
When analyst start to wake up the problem is likely on both sides.

So also for this reason (next to keep the electorate in the UK a bit calm (real calm will unlikely happen))imho they are all best served by solving the issue asap.
And with as little as possible media noise. For Cameron that is much easier when it is done in say 2 years than when it gets a 5,6,7 etc year long project. It will start to play anytime elections come around, looks simply unavoidable and with a highly uncertain outcome if the UK public simply gets enough of it. Which would mean they will most likely push for a clear out. At least it looks that way from the polls.
If Cameron has little to show before next election it likely will come up if he has things to show it probably will calm down somewhat.

jon livesey said...

Unfortunately, in all these discussions people approach things with a very sixties "Sterling crisis" mentality.

In the Sixties, you could have a Sterling Crisis because there was a fixed exchange rate to defend, and the only way it could be defended was by using foreign exchange reserves, which were limited in size.

Also, the UK typically ran consistently higher wage/price inflation than its main trading partners, so getting into a situation where the only alternatives were to spend reserves, or devalue, and usually the one followed by the other, was periodically inevitable.

Today's situation is radically different. The market trades Sterling to some level it is comfortable with, and there is no necessity to spend reserves.

Despite what the column asserts, the devaluation since 2007 has been very beneficial for exports, which have risen by 25% in that time - the UK now exports more than France - leading to employment in export oriented businesses remaining high, one of the factors we have lower unemployment that the euro-area.

And there is no evidence at all that even if Sterling were to slide further this year, this would be "not good for the UK economy".

Rollo said...

1. The debate is about IN-OUT. Obviuosly we still want to trade with Europe; even more, they need to trade with us. But we do not want to continue to throw money and effort into the sinking ship of EU. We need OUT of the EU; and then we can choose if, or not, to adopt some EU ideas.
2. No, the pound will not take a beating. The Euro is not a currency, it is a fake construct. It is far too high for some member states, and is destroying them; and it is too weak for others, which they like because it enables them to export. Every time the ECB promises stability, the Euro increases in value; but it is only blown up by hot air.
We should not measure the pound against the Euro but against real currencies.

Denis Cooper said...

The enemy propagandists who infest the comments sections of certain British newspapers, notably the Telegraph, often pick up on some exchange rate movement to claim that sterling has collapsed, or is collapsing, or will collapse.

But when I check the sterling trade weighted index I find that sterling has been fairly stable for more than four years now, and there has been no substantial downward movement in recent weeks or months - it was 81.6 yesterday, at about the same level as ten months ago - and so I continue to view their predictions of an impending collapse with scepticism.

Rik said...

Just been looking around, marketwise that is, a bit.

Get the following idea:
-Markets are mainly afraid for the UK economy. In the way that it would hurt it a lot if there is a simple exit. Probably can be solved easily, that one way or another the single market will remain. A simple exit without having clear what it would do to the economy will likley lead to a sharp market reaction (before that if it would become a real possibility). Hardly surprising.
-as expected nobody considered yet really the impact on the EU (first articles appearing now, likely that will start to play). But didnot see anything or spoke anybody who had the whole picture. It being both the economy and the sustainability of the Euro/EZ/EU. Both points start to come up now but still isolated. It is one or the other.
-looks like a Brexit is seen as a bigger problem than a Grexit if asked specifically. Some obo a more or less proper analysis. Like: makes the EU not a nice place for Northern Countries, stuck with a majority of likely long term basketcases and protectionism. Others simply as they have problems make a distinction between EU and EZ.
So my calculated guess is that it will likely be seen as a bigger problem than a Grexit by markets.