In our previous piece on pound sterling, we wrote that the currency was likely to weaken thanks to (1) slowing growth across Europe, (2) excessively bullish speculator sentiment and (3) Brexit-related woes. Thanks to the UK’s significant trading ties with the EU, we wrote that the pound was unlikely to escape a slowdown across the region. Furthermore, speculator positioning in the pound looked excessive at the time, exacerbating any potential downturn.
Following the publication of our last commentary, the pound has fallen by almost 6% against the US dollar. Specifically, GBP/USD was trading at 1.3550 on May 7 and traded as low as 1.2740 on August 20. While the pound’s performance against the US dollar (-5.5% year-to-date) is nothing to celebrate, the Australian dollar (-6.4%) has fared even worse. While we expect the pound to weaken further (especially against safe haven currencies such as the US dollar), there are some hopeful signs for the future.
Inflation set to weaken as base effects catch up
Following the Brexit referendum vote, pound sterling fell sharply against its major peers. In turn, this led to a significant acceleration in inflation as the price of imported products (such as commodities) surged when priced in pounds. Going forward, we argue that UK inflation is past its peak and is more likely to decelerate over the coming months. An overview of historical UK headline inflation is shown below:
Source: UK ONS, US Federal Reserve, MarketsNow
As can be seen above, UK inflation rose sharply in 2017 in response to a weaker pound. Thanks to rising prices of imported products, headline inflation peaked at 3.1% in late 2017 (indicated in red above). The GBP/USD exchange rate is inversed and shown with a 7-month lag for effect.
