(01/26/10) 2010 Outlook for the British Pound

Since January 2007, the pound has dropped -23.5% against its major trading partners with the decline against the euro slightly more than that against the dollar. Although the pound managed to gain against most of these partners in 2009, much of the return was erased in the second half of the year as the BOE committed to adopt extremely loose monetary policies and economic contraction was more serious than previously anticipated.

In 2010, we expect the pound will remain weak in the first quarter, as there are still uncertainties in how the nation's economy will develop and whether the central bank will expand or unwind stimulus policies. However, things may be clearer towards the second half of the year. More rapid economic growth (compared both with 2009 and with other OECDs) and improvement in fiscal conditions may help lift the pound. That said, 2010 will be a year full of variables in the UK. The election, exit of monetary policies, and return of VAT to 17.5% are all important issues for the British economy this year, and their impact on economic development and the nation’s currency are yet to tell.

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Economic Outlook: The economy should have grown slightly in 4Q 2009 after contracting almost -6% in the first three quarters. Forward-looking indicators have been improving and net trades have been boosted by weakness in the pound (against a basket of currencies, sterling has dropped more than -20% since 2007 and -4.4% since July 2009). In 2010, recovery is expected to continue, although the path should be gradual and bumpy—a situation similar to most advanced economies. The OECD forecast UK's GDP to expand +1.2% in 2010 and +2.2% in 2010, after tumbling -4.7% in 2009.

These are compared with corresponding growths of +0.9% and +0.9% in the euro zone and +2.5% and +2.8% in the US.

The UK inflation jumped +2.9% y/o/y in December, +1% higher than the increase in November as oil price rallied while reduction in sales tax in 2008 was not repeated. This is the first time since May that inflation has exceeded BOE's target of 2% and we forecast the rise may speed up in coming months as VAT has returned to 17.5% from 15% last year, since January 2010. However, this is premature to predict an early tightening by the central bank. In fact, the MPC expected a spike in CPI. At November's inflation report, the BOE said that inflation will accelerate and then dip below the 2% target and the rate will not return to the target until 2012.

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NEXT: Assessing UK Monetary Policy

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The labor market in the UK has been resilient. The -15.2K decline in claimant count in December was the biggest drop since early 2007. Moreover, the decline in ILO unemployment rate to 7.8% in the September-November period from 7.9% in the August-October period also evidenced that the job market has performed better than expected since the beginning of the recession.

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Monetary Policy: Same as its counterparts in the advanced economy, the UK implemented a series of conventional and unconventional measures to stimulate growth. The BOE cut its policy rate to from 5% to 0.5% in the five-month period from October 2008 to March 2009. The interest rates are expected to stay unprecedentedly low until at least late 2010. Moreover, policymakers also started buying assets in March 2009 and the size was increased from GBP 75 billion in the beginning to GBP 125 billion in May, GBP 175 billion in August, and then GBP 200 billion in November.

It's a difficult task to forecast the BOE's policy as it surprises the market very often! In July, the market had expected the BOE would extend the asset-buying program by GPB 25 billion because it would be ending at the end of July, before the August meeting. Therefore, in order to avoid discontinuity, it's tactical for the central bank to extend the plan to GBP 150 billion, which was the total amount authorized by the Chancellor at that time. However, the outcome was that the MPC members decided to stick to GBP 125 billion (May's decision).

After the meeting, the market widely anticipated the BOE would slow down the pace of purchases so that the whole program would extend beyond the meeting on August 6 until policymakers could acquire more information from the Quarterly Inflation Report in August about the impact of the existing monetary and quantitative easing policies.

While the market had expected the BOE would put everything on hold in August, it extended the asset-purchase program by GBP 50 billion to GBP 175 billion as “the recession appears to have been deeper than previously thought. GDP fell further in the second quarter of 2009. But the pace of contraction has moderated and business surveys suggest that the trough in output is close at hand. Underlying broad money growth has picked up since the end of last year but remains weak. And though there are signs that credit conditions may have started to ease, lending to business has fallen and spreads on bank loans remain elevated.”

Another move was seen in November when the BOE raised the size of the program by another GBP 25 billion to GBP 200 billion, probably because the unexpected economic contraction in 3Q 2009 suggested dismal outlook in the country.

The next move will be in February when the Quarterly Inflation Report will be released. We and the market expect policymakers will announce a pause in QE at the meeting. A “pause” in QE has good and bad implications. The good thing is that the BOE may think that there's evidence that economy in the UK has shown signs of improvement and previous easing programs are sufficient to drive growth. Moreover, putting an end to liquidity provision should be supportive for sterling, which was being dumped in the second half of 2009 due to BOE's aggressive QE. On the other hand, if the BOE announces it as a “pause,” it means there's possibility for further extension of the program should the economy deteriorate. While both the ECB and the Fed have shown signs of unwinding their liquidity programs, potential expansions of QE by the BOE is really negative.

The BOE's monetary policy will even be harder to gauge this year as fiscal and political issues are playing important roles in the monetary outlook. In short, substantial fiscal tightening will prolong the accommodative monetary situation, while how aggressively the government will work to cut the budget deficits greatly depends on which party wins the general election, which must occur by June 3, 2010.

NEXT: Likely Impact of UK Election on GBP

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Fiscal Policy and Election: The UK is running at huge deficits and the government said in the pre-budget report that public sector net borrowing (PSNB) will increase to 12.6% of GDP in 2009/10 while public sector net debt (PSND) will rise to 55.6% of GDP during the period. While the former should be more than halved by 2013/14, the latter will probably surge to 77.7% by 2014/15. IMF forecast in October that UK's net debt will rise to 75% of GDP in 2010 before 2010.

Credit agencies have warned that the nation's deficit problem is hurting its credit rating. While Moody's said on December 8 that the UK may test the Aaa boundaries, S&P lowered the outlook on the country's AAA rating to “Negative” from “Stable” in May.

The three political parties in the UK have pledged to tighten fiscal policy as the economy recovers, but the Conservative party appears to be the most aggressive one regarding the issue. The opposition party said the current Labor Party government's plan to halve the deficit in four years is not enough and the cut needs to start immediately. Last week, the shadow Chancellor of Exchequer, George Osborne, said he will target programs that “represent poor value for money,” including spending on advertising and consultants. Tax credits for people earning more than GBP 50 000 and tax-free child trust funds for “better off families” will be cut during the financial year. Currently, opinion polls show that the Conservatives are 10% ahead of the Labors in opinion polls.

The pound should be lifted with a hope of narrowing fiscal deficit. Therefore, it's possible for GBP to rebound after weakening in the first quarter as the election gets closer. However, the rise should not be too strong as fiscal tightening may hinder economic recovery and prolong the low-rate monetary policy.

If the election result replicates the polls, a lead of around 9-10% should produce a Conservative majority. However, if that's not the case, a hung parliament—with no party having an outright majority—could cause sterling to fall as well as increase the difficulty in coming up with an agreed approach to tighten fiscal policies.

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