FxPro Forex Analysis: Sterling in 2014 – good and bad

The story of sterling is familiar to all, namely one of continued disappointment on growth (lower) and inflation (higher) weighing on its shoulders. This started to turn in the twilight of Mervyn King’s tenure at the Bank of England, with growth for the year seen around 1.5% (expectation was for 0.8% back in May).

The currency has naturally responded in kind, the strongest performer on the majors in H2. This has happened despite the Bank’s attempt at forward guidance, offering assurance to markets that rates will stay low so long as unemployment remains above 7% (with lots of caveats).

But there is good growth and bad growth. The investment and net export-led economy that the Bank has so long wished for remains largely absent. Since 2010, residential investment has accounted for 20% of the cumulative growth in the economy. Business investment has detracted more than 1% from the cumulative 4% growth in the economy over this time.

Net trade (exports minus imports) has done better, contributing to 20% of the growth, but has deteriorated more recently and the stronger pound and shaky eurozone recovery don’t paint a particularly bright future.

All well and good, but when does the currency start to care? Up to now, it has been happy with the headlines. When we are talking more about risks, then it’s harder to predict the exact timing of how these are going to evolve. Certainly, near-term there is a sense that sterling has run away with itself, the disconnect between sterling and the data at the widest for over a year. An earlier move on tapering from the Fed may also support such a correction.

So for sterling it could well be a year of two (uneven) halves in 2014. Early on, positive growth dynamics could still provide some support for sterling. Furthermore, there is the issue of inflation. This is going to be more of an issue than for the eurozone, largely because of capacity destruction over previous years. The Bank won’t feel confident enough to increase rates, but real wage growth will remain negative. Recent growth has been reliant on the housing market and households running down savings. This can’t continue, but the lack of recovery in business investment has been the single biggest disappointment in the past 3 years. Low rates, a slower economy and continued inflation stickiness are why we see sterling lower through most of next year.