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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is global head of FX strategy at Union Bancaire Privée
Whisper it — sterling may be in for a period of decent appreciation. This may sound like a disputable statement following many years in the doldrums since the Brexit referendum in 2016. However, there are increasing signs that the pound is set to embark on an upward trend.
The rapid fall in UK inflation since a peak in 2022 — both headline and core — has prompted inflation-adjusted real interest rates to move towards positive territory. This is typically highly supportive for any currency and is an unusual feature for sterling, which in recent years has almost always had a negative real interest rate profile.
The Bank of England’s cautious rate-cutting cycle, which now looks increasingly likely to begin in the second half of the year, will only slowly reduce base rates — meaning that the pound will enjoy a prolonged period of positive real rates.
This should benefit the pound all the more considering the widespread improvement in external economic conditions, which tends to boost currencies with a high correlation to global growth, such as sterling. With front-end US government bond yields having probably peaked and set to contract over the coming months, cyclically sensitive two-year interest rate spreads should move in favour of sterling in the second half of the year — thus supporting higher pound/US dollar levels.
Easing inflation will also benefit hard-pressed UK consumers, who have experienced the longest period of falling living standards since the Napoleonic wars two centuries ago. Because of the tightness in the UK labour market, average wage growth is likely to remain well above inflation levels over the coming two years.
This means that Britain is set for a large rise in real (inflation-adjusted) wages, which is positive 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 readings. Given that many UK household balance sheets are now in better shape than a couple of years ago, any increase in real wages is likely to be consumed, thus providing further support for overall economic growth.
The housing market, which has been depressed for the past three years, is set to experience the release of pent-up demand in the coming quarters — which has wide multiplier effects elsewhere in the domestic economy.
The UK’s perennial current account deficit, at about 3 per cent of gross domestic product in 2023, is also showing signs of improving. Alongside a recovering trade balance, this implies that there is little if any pent-up depreciation pressure on sterling. This will limit any significant downside for the pound over the coming months and quarters.
UK chancellor Jeremy Hunt has also been steadily unwinding the appalling fiscal legacy of former prime minister Liz Truss, such that UK fiscal dynamics are no longer a pressing concern for international investors.
Put simply, the pound’s previous vulnerabilities are no longer as apparent in today’s market.
The country’s forthcoming general election, which is set to be held over the coming year, is widely expected to result in a huge Labour majority in the next parliament. It could even give the pound a big boost. Investors tend to underrate Labour’s pro-business stance — evidenced by the widespread domestic and overseas business attendance at its party conference last year.
Labour has traditionally had a more constructive stance towards the EU than the Conservatives and this can go some way towards improving foreign direct investment trends, which have lagged behind the major economies since the Brexit referendum.
Any increase in foreign investment in the UK will be welcome, but may be overshadowed by substantial foreign capital inflows towards the domestic equity market in the short term. The international equity rally has continued to spread, and both the FTSE 100 and FTSE 250 are trading at comparatively 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 upgrades from companies — and a stampede of investors looking to benefit from one of the last value pockets in the major economies.
The bottom line is that the stars are aligning for a sterling rally over the coming months. Whether this can be sustained over the longer term is an entirely different matter — one that would require a material improvement in UK productivity growth, which at this juncture appears to be a tall order.
