It looks like nothing can stop the British pound from falling to new lows.
With inflation set to top 18% next year and families across the country expected to face fuel poverty this winter, Britain’s economic woes are getting worse by the day. Traders agree the Bank of England will have no choice but to force the economy into a deep recession and cause widespread job losses to rein in price pressures.
It has put historic lows for the pound within reach. The currency is trading around $1.18, less than 4 cents from its weakest level since 1985 against the dollar, underscoring the challenges facing the UK economy and the next Prime Minister. The BOE is already forecasting a five-quarter recession beginning later this year.
“Are there any other disadvantages? Yes, absolutely,” said Geoff Yu, senior currency strategist at Bank of New York Mellon Corp. “Even if things improve, sterling cannot return to previous levels of 1.40 or 1.45 dollars. That will be very difficult to achieve.”
The rise in energy prices is feeding through financial markets with higher inflation forecasts, leading traders to believe the BOE needs to be more aggressive. Money markets are now showing expectations that interest rates will rise by 4.25% next year, the highest since 2008. This is also driving bond yields higher, with 10-year rates rising to 2.59%.
In theory, higher interest rates should result in a stronger currency. But for the UK it is just the opposite. Investors believe further aggressive increases in borrowing costs – needed to slow price growth – would deepen the UK’s economic malaise and leave the country worse off compared to the US and the eurozone.
“Interest rates will not always be enough to support a currency when the trade-off between growth and inflation is so poor,” said Kit Juckes, chief currency strategist at Societe Generale SA in London.
UK inflation hit a 40-year high of 10.1% yoy last month and Citigroup Inc. said it could rise above 18% in January. More than half of UK households are at risk of being pushed into energy poverty this winter by rising bills, according to consultancy Baringa Partners.
Here’s a snapshot of what’s happening in other UK markets:
Selling off bonds
UK short-end benchmark bond yields – which are most sensitive to changes in monetary policy – are expected to rise by a record this month. Two-year yields have risen 111 basis points, pushing the cost of borrowing to 2.82%, the highest since the global financial crisis in 2008.
The weaker pound has given major UK exporters a boost and the FTSE 100 index is up 0.3% in August. However, recession worries are weighing on smaller companies, dragging the FTSE 250 Index down 4.6%.
corporate debt gap
Short-dated corporate bonds underperformed this month on inflation fears. The excess return investors demand for holding sterling notes rather than euro-denominated debt has risen to its highest level in years.
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