Tuesday, July 16

Why the pound is in freefall

The pound has tumbled to a six-month low against the US dollar as traders predict the end of interest rate rises from the Bank of England and as America’s economy proves remarkably resilient.

Sterling has dropped to $1.215, a level not seen since March and a sharp drop from its peak above $1.31 in July. The currency has fallen more than 3pc against the dollar so far this month and is now on track for its worst month since the aftermath of the mini-Budget last year.

However, it remains well above the extraordinary depths of $1.068 plumbed a year ago in the wake of Liz Truss’s fiscal statement. Then, a bond market crunch took hold and shook confidence in Britain.

This time around, it is not so serious. However, the weaker currency threatens to add to inflationary pressures and could make it harder for Rishi Sunak to meet his goal of halving inflation by the end of the year.

Why is the pound so weak?

Much of it comes down to interest rates. Rising interest rates draw in money from around the world as investors seek higher returns, pushing up the currency.

The pound peaked against the dollar in July when the Bank of England was raising borrowing costs rapidly and markets thought the Federal Reserve, in the US, was about to end its run of increases. Investors shifted their investments from dollars to sterling as a result.

In July, investors believed the Bank of England was on track to take interest rates to 6pc by the end of 2023. However, signs of a cooling job market since then and a surprise fall in inflation last month have forced traders to tear up their assumptions.

Last week, the Bank held rates unchanged for the first time in almost two years and the markets now believe borrowing costs have peaked at their current level of 5.25pc.

The pound dropped sharply after the Bank’s latest decision and has fallen further since. Sandra Horsfield, economist at Investec, says these changing forecasts for interest rates have caused a good part of this overall underperformance of sterling.

It wasn’t long ago that markets were still pricing almost 6.5pc as the terminal level of Bank rate,” she says. “That has come right back down, and has represented a much bigger re-pricing of interest rate expectations than elsewhere.

However, the pound’s weakness is also being driven by the strength of the dollar. The euro, which is unperturbed by the actions of the Bank of England, has also fallen to a six-month low against the greenback, indicating the worldwide strength of America’s currency.

The euro now trades at $1.056, having peaked at $1.124 on 14 July. The dollar has surged after projections published by the Fed showed officials expect to keep US interest rates above 5pc next year, compared with previous forecasts they would cut to around 4.6pc.

Projections also show the world’s largest economy is set to grow by around 2pc this year, 1.5pc next year and 1.8pc in 2025. By contrast, the Bank of England only expects the UK economy to grow by just 0.5pc this year, the same slow rate in 2024 and a meagre 0.25pc in 2025.

In relative terms, the pound has slumped a touch further than the euro. As well as a six-month low against the dollar, sterling is at its lowest level against the single currency since May.

Partly, this is because the pound performed better than the euro at the start of the year meaning it had further to fall. Horsfield says Britain’s economy appeared to be dodging the crunch hitting the eurozone, prompting investors to buy into UK PLC.

Now, the effects of successive rate rises are catching up to the UK. Recent business surveys show the economy is slowing down, reducing the gap with the continent.

Analysts at Nomura and at Goldman Sachs have both warned the pound has further to fall, predicting a drop to $1.18. That would be the lowest level since February.

Jordan Rochester, analyst at Nomura, said further weakness was likely because of declining foreign investment into the UK, outflows from funds, and the end of Bank of England’s rate rise cycle. Meanwhile, the Fed’s hawkishness and the strength of the American economy should support the dollar.

Only a surprisingly strong resurgence in British economic data would change the picture, according to Kamakshya Trivedi at Goldman, by pushing the Bank of England back towards a more ‘forceful’ response.

However, such a shift would likely take some time to play out, he added. Do not expect your holiday dollars to get any cheaper just yet.

All of this is bad news for the Prime Minister and his Chancellor, Jeremy Hunt. A weaker pound means imports cost more and will make the goal of controlling inflation harder to achieve.

It is particularly damaging because of the timing: the pound is weakening just as the price of oil climbs. Brent crude is up almost one-third from June’s low of just under $72 per barrel to more than $94. As the commodity is priced in dollars, the impact for British buyers is even worse.

This is already being felt at petrol pumps. The average litre now costs 155.4p, according to the Department for Energy Security and Net Zero, up from below 143p in June.

If inflation falls more slowly, or even stops falling altogether, it is bad news for the Chancellor: interest payments on one-quarter of the £2.6 trillion national debt are tied to inflation, leading to more strain on the public purse. An extra 1 percentage point on inflation adds roughly £6bn to annual debt interest costs.

Hunt has already warned that tax cuts in the November Budget are virtually impossible. Already facing a very difficult election campaign next year, the pound’s decline will only add to Sunak and Hunt’s woes.