The British pound has been among the more consistent positive performing currencies in the developed world particularly in the second half of 2013 as it became more evident that the UK economy had truly embarked on the road to recovery.
In fact, between August and December 2013, the pound sterling gained 8.9 per cent against the US dollar and a more modest 2.2 per cent against the euro.
The trend as continued in the first few weeks of 2014 on the back of further evidence that the British economy continued to improve including the confirmation of 1.9 per cent growth in GDP during 2013 – its fastest growth rate since 2007.
During the first few weeks of 2014 sterling appreciated by 1 per cent against both the US dollar and the euro to $1.67 and €1.22 per £1 respectively.
Nonetheless, it is noteworthy to highlight that the British pound had a shaky start to 2013 as the country lost its ‘AAA’ rating by both Moody’s and Fitch (although Standard & Poor’s confirmed the country’s highest possible rating). Both international rating agencies cited a bleak outlook for their downgrade.
The lack of confidence in the British economy forced the sterling to a 16-month low against the euro and an almost three-year low against the US dollar during the first part of 2013. However, with the intervention of the Bank of England and the fiscal policy measures implemented by the UK government, the country’s progress exceeded all expectations.
In fact, last week, the Bank of England issued its quarterly update on economic forecasts. Governor Mark Carney was less conservative than many analysts expected and he revised economic growth projections upwards for 2014.
The Bank of England now expects UK GDP growth of 3.4 per cent this year compared to the earlier forecast of 2.8 per cent. Moreover, the Bank of England also reduced its inflation expectations.
Financial analysts argue that the focus by the Bank of England is now on how quickly the bank rate will rise as opposed to the views some months ago of whether interest rates will actually rise or otherwise
The Governor stated that the monetary policy committee “will not take risks with this recovery” and added that rate increases “will be gradual and limited”. This provided a confirmation that borrowings costs would remain at 0.5 per cent for the rest of the year since Mr Carney also stated that the economy recovery is so far “neither balanced nor sustainable” and therefore the UK still required the emergency measures adopted five years ago to counter the worst recession since the Second World War. The Bank of England Governor also warned about the increasing risks to the global economic recovery due to the problems across emerging market economies.
However, the consensus on the stronger economic growth projections and weaker inflation outlook boosted expectations that the Bank of England will start hiking interest rates in mid-2015. The Bank of England’s base rate has been at the historically low level of 0.5 per cent since March 2009.
As a result of higher rate expectations some time next year, the yield on the 10-year UK gilt rose to 2.8 per cent. The yields on British government paper have been on an upward trend in recent months as the economic indicators have been pointing towards an improving performance leading to expectations of a start of interest rate increases.
As yields have been increasing, conversely bond prices have been falling and this trend could continue in the coming years driven by an improved economic performance and expectations of higher interest rates.
The impact on longer-term bonds is greater and as such investors should focus on shortening the maturity on their sterling-denominated bond portfolio to limit this negative impact. This trend is also taking place across USD bonds and to a more limited extent in euro bond markets.
The Governor, Mark Carney, stated that “if and when the time comes that the economy can sustain higher interest rates, the bank rate is expected to rise only gradually”. Financial analysts argue that the focus by the Bank of England is now on how quickly the bank rate will rise as opposed to the views some months ago of whether interest rates will actually rise or otherwise.
Naturally, the Bank of England also explained that when interest rates start to rise, they would remain “materially lower” than the level before the start of the financial crisis in 2008 when interest rates were at 5 per cent.
Some analysts claim that rates will increase gradually as from mid-2015 and reach a level of 2 per cent by 2017.
Shortly after coming into office last summer, Mr Carney, the ex-Governor of the Bank of Canada, had linked a future interest rate hike to a drop in unemployment towards the 7 per cent level from the level of 7.8 per cent at the time. This was expected to materialise in early 2016.
However, in view of the fact that unemployment dropped much quicker than expected, this time the Governor of the Bank of England did not link an upward movement in rates to any specific single economic indicator. Instead, he said that the bank’s monetary policy committee would be “monitoring a broad range of indicators”.
Given the expectations of a hike in interest rates in the UK some time in mid-2015 while at the same time, the European Central Bank is expected to further ease monetary policy due to fears of deflation, sterling is expected to continue strengthening against the euro in the coming years.
International economic commentators are predicting that sterling will strengthen by a further 2.4 per cent against the euro by the end of 2014 to a level of €1.25 and to stabilise at this level during 2015.
However, the positive forecasts may be derailed by the wide UK trade deficit (imports higher than exports) which reached its highest levels in the last 25 years.
The country’s trade deficit should eventually narrow through slower growth or currency depreciation.
Additionally, forecasts might be temporarily distorted by the potential uncertainties that may emerge if the Scottish electorate vote in favour of becoming an independent state (and consequently split from the United Kingdom) in a referendum scheduled to be held on September 18, 2014.
Although Maltese investors naturally have the majority of their investments in euro, many investors have exposures to sterling.
Therefore, such investors should also take currency expectations into consideration. Given the overall decline in the value of sterling since 2008 and the positive outlook for sterling in the near term, investors would be very much inclined to retain and possibly also increase their exposure towards sterling-denominated investments.
This could instigate some of the issuers seeking to raise funding through a bond issue across the local financial market in the coming months to possibly also consider a sterling denominated tranche to raise the required amount of funds.
Rizzo, Farrugia & Co. (Stockbrokers) Ltd (RFC) is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the issuer/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC, on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC nor any of its directors or employees accept any liability for any loss or damage arising from the use of all or any part thereof, and no representation or warranty is provided in respect of the reliability of the information contained in this report.
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Edward Rizzo is a director at Rizzo, Farrugia & Co. (Stockbrokers) Ltd.