G10 FX Weekly: GBP Set for Downside in 2H 2023

Summary

• UK economic data, most notably inflation and employment readings, have soured recently.
• So far this year, the British pound has shrugged off this challenging data backdrop.
• In the second half of 2023, expect the deteriorating data to negatively impact sterling, with Brexit also set to keep dragging on the UK economy and currency.

Market Implications

• Bearish GBP. Expect the Deutsche Bank GBP trade-weighted index (TWI) to trade near the low in March, roughly 4.5% lower than now.
• Bearish GBP/USD. Cable currently trades ~2% below its recent high earlier this month. The pair could trade back to the low in March, near 1.18.
• Bullish EUR/GBP. The pair has traded in a relatively tight ~0.8580/0.8980 range so far this year. In the coming months, expect the euro to revisit the year-to-date (YTD) high near 0.9000.
• Bearish GBP/CHF. The pair currently trades near the top of its ~1.1000/1.1400 YTD range. In H2, expect GBP/CHF to trade below 1.1000 as haven demand intensifies.

Introduction

The British pound is one of only two G10 currencies, along with the Swiss franc, to trade higher vs the US dollar so far this year.

The currency’s relatively strong YTD performance has surprised us. Back in February, we wrote a piece spelling out our bearish GBP bias. We thought most sterling pairs would trade in ranges, and we favoured fading any GBP strength within them.

Since then, the pound has broadly traded within the parameters we highlighted, although it has been more resilient than we anticipated.

We think this dynamic is about to change and that the pound will now gain downward traction and test the lower end of the ranges we identified a little over three months ago. Poor economic data, exacerbated by the continuing drag of Brexit, will drive GBP underperformance. The resilience so far this year will give way to weakness in H2 2023.

GBP So Far This Year

The Deutsche Bank GBP TWI has defied our expectations and traded ~3.5% higher in the first five months of the year.

That GBP has been one of only two G10 currencies to gain versus the USD in 2023 has set the tone for most sterling pairs, with the pound outperforming all its G10 counterparts.

The biggest outperformance has been against the Norwegian krone (GBP/NOK is up ~13.6% in 2023), the Japanese yen (GBP/JPY is up ~8.9%) and the New Zealand dollar (GBP/NZD is up 8.2%).

UK Data Will Be a Problem for GBP

Recent UK data prints have caught our attention, especially inflation and employment. We now explain why we think they will drag on the currency.

Inflation Data Is the Biggest Worry

While other G10 countries and currency areas have seen palpable progress in reducing inflation, the UK is a notable laggard.

Although headline inflation printed sub 10% for the first time in eight months in April, the 8.7% year-on-year (YoY) reading is still well above most comparable prints in the G10. This most recent inflation data came in stronger than the consensus expectation of 8.2%. More importantly (and worryingly), however, was that core inflation rose from 6.2% to 6.8% YoY in April even as headline dropped.

My colleague Henry Occleston concludes that inflation is stickier than the Bank of England (BoE) assumed, justifying further policy tightening.

Market pricing has certainly shifted more hawkishly since the data was released last week. On 23 May, one day before the print, markets expected 60bp of tightening by yearend. Now, post-data, they expect ~100bp of additional tightening in 2023.

Ordinarily, additional tightening from a central bank is considered a positive for a currency, as higher domestic yields improve interest rate differentials.

But for the UK presently, persistent too-high inflation will probably drag on the pound, even if it forces more rate hikes.

The UK is currently experiencing a cost-of-living crisis, which will limit economic growth later this year as higher inflation squeezes households. In effect, inflation acts as a tax on households, crimping spending and weighs on economic growth.

And, although other parts of the G10 have also experienced cost-of-living challenges in the past year or so, these countries are now seeing relief from inflation – relief that has yet to emerge in the UK.

Commentators often overuse the word ‘stagflation’ – a combination of high inflation and sluggish growth. But it is a real risk for the UK. And if the UK economy is to suffer from these toxic stagflation dynamics, expect the pound to suffer too.

Employment Data Is Also a Worry

The most recent employment data was also less-than-encouraging. Even though nominal wages rose from the previous reading, payrolls declined by 136,000 in April. That is the biggest drop since the pandemic in 2020.

The UK labour market is loosening faster than the BoE had expected in recent forecasts, although the feedthrough to wages is a sticking point. After the data release, BoE Governor Andrew Bailey acknowledged that the UK labour market is cooling.

The decline in payrolls, versus an expected increase of 25,000, is a warning that the jobs market is less robust than previously. And it bodes poorly for the UK economy in the coming months.

And even if wages are still rising, they are falling behind price rises. So on a real, inflation-adjusted basis, wages are declining.

This challenging labour market data, together with elevated inflation, adds to the stagflation narrative in the UK. This will hurt the currency.

Data Deterioration Undermines BoE Credibility

As stagflation looms, the BoE’s role as an effective steward of the UK economy faces increased questioning. With CPI readings among the highest in the G10 (and much higher than in the US and Eurozone), you can see why.

Consequently, the BoE’s credibility is undermined. The central bank now appears reactive to the economic data and the economy beyond policymakers’ control.

That this impression is nascent is bad enough. Should it become entrenched, it will be very serious. Irrespective of how it plays out, the BoE has suffered reputational damage, which is bad for the pound.

Brexit Remains a Drag on the UK Economy and GBP

The Brexit drag is compounding the challenging economic environment in the UK. A key negative consequence of Brexit is to materially contribute to the country’s inflation problem.

According to research by the London School of Economics (LSE), Brexit is responsible for a third of UK food price inflation since 2019. The LSE found that prices rose by 25% between December 2019 and March 2023. Had the UK stayed in the EU, prices would have gained 17%.

This week, The Times outlined how the services economy, from financial and professional services to retail and hospitality, has been struggling with ‘red tape, tensions and lack of labour’ due to Brexit. And British carmakers recently warned that current Brexit rules threaten the future of the British automotive industry, with the potential loss of 2,000 jobs.

Inflation and a challenging labour market in the UK are problematic for the economy, with Brexit exacerbating both problems. All this spells downside for the pound.

A Look at Three GBP Pairs

In our piece in February, we looked at GBP/USD, EUR/GBP, and GBP/CHF. We now revisit them.

GBP/USD

After a decent run higher in the Spring, cable has now retreated ~2% from the high on 10 May.

As mentioned, the expectation for higher UK yields would ordinarily drive currency appreciation, given the better interest rate differentials.

But the pound’s drop points to the dynamic, also discussed above, where higher inflation and tepid growth lead to downward pressure on the currency.

Further, Macro Hive’s momentum models flipped net-bearish on cable last week.

All this suggests further downside for GBP/USD. We expect cable to revisit the YTD low near 1.18, seen in March, in the coming months.

EUR/GBP

EUR/GBP has traded in a relatively narrow ~0.8580/0.8980 range so far this year, with both the pound and euro near the top of the G10 league table.

If the economic fundamentals in the UK deteriorate in H2 2023 as we expect, the euro should modestly outperform sterling. EUR/GBP should trade back toward the top of this year’s range.

The most recent German and French inflation readings showed inflation continues to drop steadily and materially in the Eurozone’s two largest economies – unlike in the UK. While in the short term this may lead to noisy price action based on shifting interest rate differentials, this will be a positive for both the Eurozone economy and the euro in the medium to longer term.

GBP/CHF

The Swiss franc has been the best performing G10 currency YTD and, as we wrote in a recent piece, we expect this to continue into H2 2023.

So far this year, GBP/CHF has chopped around within a ~1.10/1.14 range, currently trading near the top of that price band.

With so much economic uncertainty already present, the franc has benefitted from a flight to safety in the FX world. We expect haven demand to continue, and intensify, in H2, with GBP/CHF trading below 1.10.

Conclusion

So far this year, the pound has defied the bearish prognosis we outlined in February. We expect sterling’s fortunes to flip in H2.

The main reason is the UK’s challenging economic fundamentals. We think persistent too-high inflation, coupled with a deteriorating labour market, will lead to something resembling stagflation.

Former BoE policymaker Michael Saunders said yesterday that the UK economy is headed for its most painful period in this hiking cycle, as the peak effects from tighter monetary policy have yet to be felt. 

This will be negative for the currency, and we will see downside emerge for sterling against the US dollar, euro and Swiss franc.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)