May 3, 2017 / 3:33 PM / 3 months ago

Sterling's election-led bounce breaks developing spiral

6 Min Read

U.S. dollar and British pound notes are seen in this November 7, 2016 picture illustration. Picture taken November 7.Dado Ruvic/Illustration

LONDON (Reuters) - The lift to sterling given by the prospect of a snap British election next month has, at least temporarily, broken a vicious circle of rapidly rising inflation that threatened to further undermine the economy and paint the central bank into a corner.

The currency's steep fall since June's Brexit referendum has aggravated inflation to 2.3 percent, above the Bank of England's 2 percent target, risking a drain on consumers' real spending power while tying the Bank of England's hands if further monetary easing were needed.

The pound has traded in a range of roughly $1.20 to $1.27 to the dollar for the past six months and many analysts said they thought it was heading back towards the bottom of that range or even lower due to fears the two-year EU exit negotiating process would bring a sharp break with the bloc.

British bond yields had been climbing on the inflation picture and the conundrum that would pose for policymakers, driving up the country's borrowing costs.

But after the election announcement on April 18, sterling rose sharply, breaking out of the top of the range to a seven-month high close to $1.30, due to indications from opinion polls that it would result in a bigger majority for Prime Minister Theresa May's ruling Conservatives.

Investors took the view that it would also boost the number of Conservatives seeking a “softer” Brexit, in which Britain keep some kind of preferential access to the EU single market rather than cutting all ties as some in the party advocate.

Few people think the pound will rise much further, but if it levels out, it should help tame inflation and ease the strain on consumers, whose spending accounts for about two thirds of economic output, breaking the "stagflationary" spiral of higher inflation and lower growth.

The turnaround has been accompanied by a reversal in bonds. The benchmark 10-year yield recently hit a six-month low close to 1 percent, having topped 1.50 percent in January.

"Sterling back to $1.30 and UK yields not moving too high, keeping easy financial conditions in place, is probably the best combination the Bank of England could have hoped for," said Mark Haefele, global chief investment officer for UBS Wealth Management, who oversees around $2 trillion in assets.

Sterling is up slightly against the euro this year and nearly 5 percent higher against the dollar. Ten-year gilt yields are 13 basis points lower year to date too.

Carry That Weight

The British economy is holding up far better than most economists had anticipated, but is beginning to feel the pinch from inflation and Brexit uncertainty. Growth in the first quarter of this year was 0.3 percent, the slowest in a year.

Economists at Barclays say the Brexit slowdown has begun, and that interest rates will remain on hold until at least 2019. The BoE will give its prognosis on the economy on May 11 when it releases its latest Quarterly Inflation Report.

The Bank halved interest rates to a new record low of 0.25 percent and expanded its quantitative easing bond-buying program shortly after the referendum last year.

Only one of the Bank's nine policymakers, Kristin Forbes, voted for a rate hike at the last MPC meeting. But Michael Saunders has hinted that he may join her, predicting that the "powerful effects" of sterling's fall since the Brexit referendum could push growth and inflation beyond forecasts.

Burkhard Varnholt, deputy global chief investment officer at Credit Suisse, which oversees 1.3 trillion francs of assets under management, notes that sterling has been "underowned and underloved" by international investors.

Positioning data from the International Monetary Market on the Chicago Mercantile Exchange at the end of March reflected that. Speculators such as hedge funds had amassed the biggest bet against sterling on record, a net short position of over 107,000 contracts.

That's been cut to 91,182 contracts, still large by historical standards but the smallest since early March.

"As investors are buying sterling again, yields are coming down because there's money flowing into gilts. Markets are doing the heavy lifting for the BoE – the BoE must be pleased with what's going on here," Varnholt said.

The FX market's outlook for the pound is brighter too. Sterling bears Deutsche and BAML both raised their forecasts on the election news, while Morgan Stanley expects it to reach $1.45 next year

However, medians in the poll of over 60 strategists, taken by Reuters in the past week, showed sterling would be worth $1.27 in a month -- just before the general election -- but then weaken to $1.24 in six months before settling at $1.25 a year from now.

Even $1.45 would be well below the pound's long-term average value. Over the past 10 years it is $1.63; over 20 and 30 years it is $1.64; and over 40 years it is $1.67, according to former MPC member Andrew Sentance.

"Growth is much more influential for the MPC than currency and bond yield movements. If GDP softens enough, any support on the MPC for rate rises could fade away quite quickly," he said.

Additional reporting by William Schomberg and Jemima Kelly; editing by Philippa Fletcher

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