More pound pain coming as central bank shifts to recession from inflation

A shift in the Bank of England (BoE)’s focus from inflation to a darkening economic outlook became the latest reason to sell the pound.The UK currency fell almost 3% versus the US dollar last week, its worst performance since late September and the biggest drop among major currencies globally. After sinking the most in a month on Thursday, sterling looks set for another dip towards parity, with banks including Mitsubishi UFJ Financial Group Inc, Bank of America Corp and Cooperatieve Rabobank UA predicting a fall below $1.10 by the end of the year.The Bank of England’s struggle to get ahead of inflation has been a key driver of pound weakness all year and the latest selloff clips the pound’s recovery from the UK’s disastrous mini-budget just over a month ago. Investors now say the growing divergence in the approach to inflation at the BoE and the Federal Reserve is a reason to shun the UK currency.Both central banks raised rates by 75 basis points this week. But Jerome Powell’s willingness at the Fed to drive ahead with more aggressive hikes than traders envisaged contrasts with his UK counterpart Andrew Bailey’s insistence that, with the nation toppling into a two-year recession, tightening expectations are overdone. For the pound, that means there’s more pain in store, according to Derek Halpenny, head of research for global markets EMEA at MUFG. “Growth that cannot withstand many further rate hikes, as is implied by the BoE, in circumstances of more sustained rate hikes elsewhere is an increasing risk,” he wrote in a note. Coupled with the UK’s large current-account deficit, it “could mean investors view further pound depreciation as the inevitable consequence,” with sterling slipping below $1.10 “soon enough,” he said. The pound’s rebound from a record-low $1.0350 has run out of steam and investors could be tempted to resume short bets against it in the face of renewed dollar strength, according to strategists at BNP Paribas. The UK currency suffered its worst week versus the euro in more than two years, and the French bank predicts another bout of selling could see it fall to 0.9300 pence per euro, from around 0.8700 at the moment. The BoE’s shift in gears comes at a testing time for the pound and the country’s gilt market. Both took a pummelling in late September after the UK government’s unfunded, and ultimately ill-fated, tax-cut plan spooked investors with the prospect of soaring government borrowing.The turbulence abated with the ouster of Prime Minister Liz Truss, but the dollar’s surge and Bailey’s pushback against sharp hikes have hurt the pound this week. Longer-dated gilt yields have ticked up, meanwhile, as investors brace for a barrage of debt supply next week that includes the second instalment of the Bank of England’s quantitative tightening program as it sells down the bonds it scooped up over the past decade to keep borrowing costs low. Now traders are waiting for Prime Minister Rishi Sunak and Chancellor Jeremy Hunt to unveil the government’s medium-term fiscal plan on November 17, which could prove the next trigger point for sterling. The spending cuts and other austerity measures they’re expected to deliver will increase the economic hardship for UK households.  “There’s a perception that the Bank of England might be a bit more growth-concerned, and therefore won’t raise rates as much. The inflation path will dictate whether they are vindicated or not,” said Howard Cunningham, fixed income portfolio manager at Newton Investment Management.  All that fuels the view that the UK will be the standout economic underperformer among Group-of-10 economies in the coming months, adding to its ongoing headache of twin deficits and keeping the bias firmly on a weak pound.At the same time, the fiscal tightening could alleviate some inflationary pressure and require less monetary tightening in the coming months, as the BoE is predicting. David Page, head of macro research at AXA Investment Managers, says this will ease the recession’s sting and, in the longer run, help the pound.“If UK policy is going to be a fiscally tight package which leads to rates peaking at a lower level, that’s something that over time makes the pound a better-value currency,” he said. “The fundamentals of the economy should be stronger and that should allow for a sterling recovery.”