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Roula Khalaf, editor of the FT, selects her favorite stories in this weekly newsletter.
The author is global head of FX strategy at Union Bancaire Privée
Whisper it: the pound could be going through a period of moderate appreciation. This may seem like a questionable statement after many years of stagnation since the 2016 Brexit referendum. However, there are growing signs that the pound is set to embark on an upward trend.
The rapid decline in UK inflation after the 2022 peak – both headline and headline – has pushed real inflation-adjusted interest rates to move towards positive territory. This is typically very supportive for any currency and is an unusual feature for the pound, which has almost always had a negative real interest rate profile in recent years.
The Bank of England’s cautious rate cut cycle, which now looks increasingly likely to begin in the second half of the year, will only slowly reduce base rates, meaning the pound will enjoy an extended period of rate cuts real positives.
This should benefit the pound even more given the widespread improvement in external economic conditions, which tends to support currencies with a high correlation to global growth, such as the pound. With short-term US government bond yields likely to peak and then contract in the coming months, cyclically sensitive two-year interest rate spreads are expected to move in favor of the pound in the second half of the year, supporting thus higher Pound/US Dollar levels. .
The easing of inflation will also benefit struggling British consumers, who have experienced the longest period of decline in living standards since the Napoleonic Wars two centuries ago. Due to the tightness of the UK labor market, average wage growth is likely to remain well above inflation levels over the next two years.
This means Britain is set for a big rise in real wages (adjusted for inflation), which is good for consumers. It is instructive to see that measures of UK consumer confidence have steadily increased since September 2022, coinciding with the peak in UK inflation data. Given that the balance sheets of many UK households are now in better shape than they were a couple of years ago, any rise in real wages is likely to be eaten up, thus providing further support to overall economic growth.
The housing market, depressed for the past three years, is set to experience the release of pent-up demand in the coming quarters, with large multiplier effects elsewhere in the national economy.
The UK’s perennial current account deficit, at around 3% of gross domestic product in 2023, is also showing signs of improvement. In addition to a recovering trade balance, this means there is little or no pent-up depreciation pressure on the pound. This will limit any significant declines for the pound in the coming months and quarters.
British Chancellor Jeremy Hunt has also pledged to resolve former Prime Minister Liz Truss’ terrible fiscal legacy, such that the UK’s fiscal dynamics are no longer a pressing concern for international investors.
Simply put, the pound’s previous vulnerabilities are no longer so evident in today’s market.
The country’s next general election, which will take place next year, is expected to result in a huge Labor majority in the next parliament. It could even give the pound a big boost. Investors tend to underestimate Labour’s pro-business stance, highlighted by the widespread attendance of domestic and foreign companies at last year’s party conference.
The Labor Party has traditionally had a more constructive attitude towards the EU than the Conservatives and this may go some way to improving foreign direct investment trends, which have lagged major economies since the Brexit referendum.
Any increase in foreign investment into the UK will be welcomed, but could be overshadowed by substantial foreign capital inflows into the domestic stock market in the short term. The international equity rally has continued to spread and both the FTSE 100 and FTSE 250 are trading at relatively low valuations. This paradigm is unlikely to last and, as UK consumers make their presence felt in the second half of the year, we can expect earnings improvements from companies – and a stampede of investors looking to benefit from one of the last pockets of value in major economies.
The bottom line is that the stars are aligning for a rally in the pound in the coming months. Whether this can be sustained in the long term is an entirely different question, one that would require a material improvement in UK productivity growth, which at this juncture appears to be a tall order.