British pound takes on ’emerging market’ characteristics, says Bank of America

A trader pauses while monitoring financial data on computer screens at ETX Capital, a contracts for difference broker, in London, Britain, Friday, October 7, 2016.

Chris Ratcliffe | Bloomberg | Getty Images

LONDON — The pound is at risk of becoming an “emerging market” currency as declining growth and rising risks cause investors to flee the pound, according to Bank of America.

On Tuesday afternoon in Europe, the British pound was down 7% against the dollar since the start of the year, trading just below $1.26 after being as low as $1.22 earlier. this month.

Short positions built up against the currency as global economic challenges from the war in Ukraine, inflation, supply chain bottlenecks and slowing growth converge with domestic risks stemming from the predicament of the Bank of England and the fallout from Brexit.

In a research note on Monday, Kamal Sharma, senior strategist at BofA’s G-10 FX, said further weakness in the pound could be expected through the end of 2022.

He also dismissed comparisons between the monetary tightening paths of the US Federal Reserve and the Bank of England, arguing that the reaction functions of the two central banks are different.

“The challenges facing the BoE are unique, as well as a supply dynamic it absolutely does not want to discuss: Brexit. A sharp downturn is never a good idea for a currency,” Sharma said. said.

“A reduction in current environmental risk and fiscal stimulus may provide some relief, but the damage has been done and the outlook for the pound looks bleak.”

The preferred way to capitalize on the “epic” fall in the pound for BofA is the euro’s advance against the pound, Sharma added.

This was echoed on Tuesday by Deutsche Bank’s global co-head of foreign exchange research George Saravelos, who told CNBC that greater optimism about European growth, as well as the “non-linear” effects of the return from the European Central Bank to positive rates, meant the euro is poised to outperform both the dollar and the pound.

“If you look at what was happening in UK inflows, they were going sideways and as soon as the ECB went negative you saw a big acceleration in UK inflows – buying, for example, of gilts British,” Saravelos said.

“As that momentum changes and the Bank of England is much closer to stalling – it’s a reluctant strain, so to speak – you should see the euro-sterling significantly higher. We see it above 90 pence by next year.”

On Tuesday afternoon, the euro was trading just above £0.85.

Britain’s economy shrank 0.1% in March and economists expect further contractions this year as the cost of living crisis takes root. Inflation jumped to an annual rate of 9% in April as food and energy prices soared.

Parallels to the 70s

At the heart of the pound’s bleak outlook, Sharma noted, is that the UK’s net international investment position has deteriorated in recent years, with overseas investors holding a large stock of UK assets.

The NIIP measures the difference between claims on UK-owned assets on non-residents and claims held by foreigners on UK residents, an important indicator of a company’s creditworthiness.

“There are two risks to this: overseas investors could repatriate some of this portfolio of UK assets if confidence in the UK economy deteriorates (change in asset allocation due to end of interest rates negative elsewhere); or that the large stock of foreign holdings of UK assets will continue to weigh on the balance of primary incomes,” Sharma said.

“Whatever the reason, the foreign trade position will become a growing concern for markets as the UK economy struggles under the weight of higher inflation and slower growth.”

UK assets are now more expensive than they were in 2021, when inflows into the country were strong, and the pound is increasingly seen as less “undervalued” than models suggest, a he added.

The Bank of England is expected to continue raising interest rates to contain inflation, after a fourth consecutive hike took its key rate to a 13-year high of 1% in early May. The Bank expects inflation to reach around 10% this year due to the Russian-Ukrainian war and ongoing lockdowns in China.

However, Bank of America strategists are increasingly skeptical of the Bank’s defense mechanism’s ability to save the pound.

“Although this is not our central scenario, we believe that the pound is in an increasingly odious position, where central bank communication is increasingly difficult, where imbalances are increasing and where the spectrum Brexit still looms large on the domestic political scene,” Sharma said.

“Investors are increasingly discussing the GBP as taking on emerging market characteristics as parallels to the 1970s resonate as one of the worst post-war decades for the UK.”

He added that the Wall Street giant feared that the “increasing politicization” of British politics could undermine the pound in a way that “would appear similar to that of emerging markets”, suggesting that investors were starting to hedge so that the the pound loses its status as a respected global currency.

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