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Update – 5 Reasons Why the British Pound is Being Pounded – Access my latest article Feb 28, 2010
How Did the British Pound Trade in 2008?
The British pound was one of the worst performing currencies in 2008. It fell to a 6 year low against the US dollar and record low against the Euro in addition to selling off against every other G10 currency. The overwhelming weakness in the currency is a direct reflection of the impact that the credit crisis had on the UK economy. In the month of December, many currencies recovered against the US dollar, but unfortunately the British pound was not one of them. Although the pound could continue to weaken in the first quarter, the government’s aggressive fiscal and monetary stimulus should help the country recover towards the end of 2009.
Official Recession in 2009
Without two consecutive quarters of negative GDP growth, the UK economy is not technically in a recession but that should change in the first quarter of 2009, when the 2008 Q4 GDP numbers are released. Growth has been slowing materially and the weakness is reflected in the British pound. GDP growth fell by 0.6 percent in the third quarter, the largest decline in 18 years. The housing market and the financial sector have been the engine of growth in UK for the past few years and both blew up in 2008. Unfortunately the worst is probably not over for the 2 key components of the UK economy, particularly following the Bernie Madoff’s Ponzi scheme. In addition to losses suffered from the subprime mortgage crisis, many large hedge funds and European banks invested with Madoff’s. In 2009, they will be forced to write down those losses and deal with what could be pretty severe consequences for the financial sector as a whole. With the financial and housing market sectors expected to remain weak in the first half of 2009 and layoffs predicted to rise, GDP growth could fall as much as 2 percent next year. Although we believe that the country could be one of the first to recovery from the global economic downturn, this will not before more pain is felt in the UK economy. The severity of the UK recession will be largely dependent upon how quickly the credit markets are restored in 2009.
Inflation to Fall Back to 2%
Even though falling oil prices has driven inflation lower in the UK, the annualized pace of consumer price growth is still well above the central bank’s 2 percent target and even higher than their 3 percent upper limit. The latest data is for the month of October and according to that report, consumer prices rose 4.1 percent yoy. Despite the high level of inflation, the central bank has pretty much abandoned the inflation target and shifted their focus back to growth because they believe that the slowdown in the economy will naturally drive inflation lower. They believe inflation could fall back to 2 percent as early as the first quarter.
More Rate Cuts in First Half of 2009
Next to the Federal Reserve, the Bank of England has been the most aggressive central bank in 2008, having cut interest rates by 350bp to 2 percent, the lowest level in 57 years. Despite the massive interest rate cuts, tax cuts and other fiscal stimulus, the Bank of England remains committed to doing all that it takes to prevent a recession from sparking deflation. Central Bank Governor King believes that the economy will contract in 2009 and given his pledge UK interest rates could fall by another 100bp in the first half of the year. Although zero interest rates are not expected in the UK, interest rates will fall below 2 percent and until the Bank of England is done easing, the British pound may remain weak.
EUR/GBP at Parity
The sell-off of the British pound in the first few months of the year could drive EUR/GBP to parity. If that happens, it would be the first time ever that one Euro would be worth more than one British pound. This could not come at a better time than 2009, when the Euro celebrates its 10-year anniversary. In this past decade, the currency has risen from ashes to become more valuable than the 2 primary reserve currencies in the world. Although many Britons may be alarmed at the weakness of their exchange rate, the Bank of England will probably not step in to stop it from falling. Instead, the BoE will revel in the stimulative effects of a weak currency. There are already reports of Europeans from the Eurozone flocking to the UK for their holidays. The weakness of the British pound against both the US dollar and the Euro are key ingredients for an economic recovery.
Keep an Eye Out for a Recovery
Although the UK economy still faces many risks in 2009, there is hope. Consumer spending has been pretty resilient with November retail sales rising for the first time in 3 months. If the global economy begins to recover, we expect the UK economy to outperform its peers thanks to the Bank of England’s proactiveness. The currency has sold off significantly, providing additional stimulus for the battered economy. Even if there is no full-blown recovery, the UK economy is much further long in their slowdown than the Eurozone. Therefore if we see sharply weaker growth in the Eurozone economy in 2009, expectations for more aggressive ECB interest rate cuts may be all that the British pound needs to recover against the Euro. As for the US dollar, the recovery could come sooner if the quantitative easing forces the greenback lower. When the UK economy begins to recover, so will its currency.
For my technical forecast for the GBP/USD, read my full 2009 currency market forecasts on GFTForex.com