This post will discuss the recent downgrade of the United Kingdom by Moody’s Investors Service, why the Bank of England may be ill-prepared to act, and why the Government’s refusal to act could keep the British economy, as well as the British Pound, in the gutter for 2013.
As the last week of February arrived, the British Pound found itself in a precarious position: it was the worst performing major currency in 2013. Yes, worse than the Canadian Dollar; yes, even worse than the Japanese Yen. Yes, the Japanese Yen! This is quite astounding, purely because the Bank of Japan and the Japanese government are working double-time to Yen in order to foster inflation, introducing significant stimulus on both the fiscal (new spending programs) and the monetary (doubling the inflation target and introducing an open-ended QE program to begin in January 2014) fronts, while the Bank of England appears to continue to sit on its hands.
Two central banks, moving in slightly different directions, and yet the more aggressively-dovish one doesn’t have the weaker currency. This truly emphasizes how weak the British economy is, and why it is likely that the British Pound remains weak, alongside its economy, for the rest of 2013.
Growth has been modest at best, with the 4Q’12 GDP print only revised to +0.3% annualized the last week of February, helping the economy elude the difficult economic condition known as stagflation, or a period of economic conditions characterized by low or negative growth, high inflation, and high unemployment. These conditions were exacerbated by Chancellor of the Exchequer George Osborne’s austerity program, a choke on the British economy, which too is heavily dependent on consumption: higher taxes take a chunk out of that 64% of headline GDP figure.
Ideally, in response to these conditions, the Bank of England would be acting. Instead, it seems unwilling to do so. The most recent policy meeting notes show that outgoing BoE Governor Mervyn King was outvoted trying to increase the central bank’s QE program by £25B. With outgoing Bank of Canada Governor/incoming BoE Governor Mark Carney talking up dovish central bank actions the past several months – going so far as to say that global central banks haven’t let “hit their limits” – it appears a low rate environment is in store for the British economy, further undercutting the British Pound.
Indeed, these fiscal and monetary forces have provoked Moody’s Investors Service into downgrading the United Kingdom from its pristine ‘Aaa’ rating, to ‘Aa1,’ giving the U.K. a split rating just like the United States. In the near-term (remainder of 1Q’13), there may be few new negative catalysts that might present themselves, preventing the Sterling from getting pounded any further. But for the remainder of the year, as the economy gets worse amid steeper austerity conditions and a BoE that will be struggling to find its new identity, the British Pound could remain one of the weakest major currencies, next to the Japanese Yen. The GBPUSD should move towards 1.4250 by the end of 2013.
This series of eight posts will focus on the major themes affecting currency markets. The sixth post in this series will discuss the diminished economic outlook for the Euro-zone, and why the crisis hasn’t been truly resolved.