The recent unravelling of the pound can be put down to a number of factors. Counterintuitively, the main one is not the recent deterioration in economic data seen in the past six weeks (to January 28).
The main reason has been the much more benign environment in Europe with respect to the European sovereign debt crisis.
In spite of continued deteriorating economic conditions in France, Spain and Italy, the fact that the German economy appears to be showing significant signs of life has prompted investors to ignore the depression elsewhere in Europe. They now believe that a German economic recovery will somehow pull Europe out of its austerity-induced funk.
This, in turn, has seen sharp declines in last year’s safe haven trades of the Swiss franc, Japanese yen and the pound as money flows out and back into Europe.
However, this flow could quickly reverse if European politicians waste the extra time afforded them by Mario Draghi and the European Central Bank.
The decline in the pound has been exacerbated by fears of an imminent loss of the UK’s triple-A credit rating, spurred by disappointing economic data in the past three months.
Purchasing managers data for the three months to December across construction, manufacturing and the services sector along with disappointing industrial production and retail sales numbers pretty much guaranteed a negative fourth quarter. This is a fact that appears to have been confirmed by the preliminary reading of fourth quarter GDP which showed a sharper than expected contraction for the fourth quarter at -0.3 per cent.
With 2013 also getting off to a dreadful start with a number of high-profile insolvencies in the shape of Jessops, HMV and Blockbuster, the retail sector, in spite of some
outperformance in some areas is likely to show a poor performance in the first quarter as well, with a number of economists predicting that the UK is headed for a triple-dip recession.
The fiscal influencers
The latest public sector borrowing numbers also appear to suggest that tax revenues are struggling to keep pace with spending, suggesting that chancellor Nick Osborne will be unable to meet his borrowing target for the current fiscal year.
With ratings agency Fitch warning that it would be reviewing the rating in March and a warning from the IMF that the current fiscal plan is hurting growth, the chancellor is caught between a rock and a hard place in trying to cut spending when there is no demand in the economy, which means tax revenues will fall.
The only bright spot has been the resilience in employment with the unemployment rate dropping to 7.7 per cent for the three months to November.
This could be as good as it gets given recent headlines about job cuts in banking and retail and could increase calls for further measures from the Bank of England to restart its asset program.
This seems unlikely given that inflation remains high and the current governor of the Bank of England appears to be attempting to talk the pound lower in an attempt to try and boost the UK’s export capability.
The downside to that is that inflation is bound to remain underpinned, which in turn suggests that the Bank will not be embarking on any further policy easing any time soon, irrespective of how bad the data gets.
US influencers
A recovery in US economic data could also have a negative effect on the pound, especially if the employment situation continues to improve. A continued improvement in this particular area could well prompt speculation of an early withdrawal of the monthly $85bn (£53.7bn) worth of bond purchases that the Federal Reserve has pledged to undertake.
With new voting members on the committee and some unease about the effectiveness of quantitative easing, the recent minutes showed that there was a significant split about the duration of the current scheme.
It remains to be seen whether the new voting members will be more dovish or hawkish with respect to this, but a continued recovery in the US is likely to put downward pressure on sterling.
The recent declines in sterling could well see the pound head back towards long-term trend line support at 1.5610 from the 2009 lows at 1.3500. The key support level lies just less than 1.5300 at 1.5270 which has been the range lows for nearly three years.
Against the euro investors could well see the single currency rise as high as 0.8600, if the 200 week moving average at 0.8540 is taken out.
Michael Hewson is senior market analyst at CMC Markets UK
