Bank of England sends sterling plunging, but is the end in sight?

We had some hope that the British pound could find its feet this week, well, how wrong were we? It has sunk an impressive 400 pips since 26th July, and after the latest Bank of England Inflation Report, GBP/USD is now testing the key $1.21 level. Where did we go wrong? We thought that the FX market would be able to cope with PM Boris’s no-deal rhetoric now that the cabinet is bolstering efforts to prepare for such a scenario. It turns out that the FX market doesn’t much like this political nuance, which means that the pound sinks every time the prospect of a no-deal Brexit gets closer to becoming a reality. 

A Recession before we leave the EU, now a possibility 

In fairness, the economic picture is not helping the situation for the pound. The July PMI survey results kicked off with the non-manufacturing sector today, it showed that the index remains mired in contraction territory at 48. On the bright side, it wasn’t as bad as some analysts had expected, they were looking for 47.7. However, the good news ends there, Brexit uncertainty coupled with the slowdown in global economic growth triggered the largest fall in production volumes for 7 years’, according to the report some companies are already moving supply chains out the UK due to the threat of Brexit. The car industry, in particular, has been sensitive to Brexit, with the head of BMW making an impassioned plea to Boris Johnson to cease his threats of leaving the EU without a deal in a few months’ time. Friday sees the release of the construction sector PMI, which is also expected to remain in contraction territory for another month. If this is the case, then the latest raw economic data does not paint a pretty picture for Q3’s growth outlook. At this rate the UK’s economy could be in contraction territory before we leave the EU at the end of October. 

BOE distances itself from Fed, ECB, no rate cuts here 

The deteriorating growth outlook seems to be the key driver of a weaker pound on Thursday. The Bank of England gave a grim assessment of the UK’s economic prospects this year and next when it released its third Inflation Report of the year earlier, cutting growth for this year and next to 1.3%, compared to the 1.5% and 1.6% forecast in the May report. It added that there was a near 33% chance of a recession in the first quarter of 2020. It blamed the slowdown in global growth as well as the uncertainty around Brexit that has thwarted companies’ spending plans for the coming years. Interestingly, this growth downgrade came even though the BOE’s base case is that the UK will leave the EU with a deal come the 31st October. The Bank has not set out any no-deal forecasts because this is not the official position of the government and Westminster is still confident that it will strike a deal with the EU before the 31stOctober deadline to leave. However, based on this week’s GBP performance, the market appears to be imagining how bad growth will look in the event of a no-deal Brexit even though the BOE hasn’t published its no-deal forecast.

Inflation more important than growth for no change BOE

GBP/USD tested the 1.21 handle on the back of the BOE Inflation Report, however, it has managed to cling on above this level at the time of writing. Interestingly, the market may be less focussed on the BOE’s growth forecasts, as we mention above, the market is already pricing in a disastrous economic outcome for the UK from Brexit, as it has been since we voted to leave in 2016. Instead we believe that the pound’s slight recovery this afternoon is based on the BOE’s interest rate forecasts. It is not predicting a rate cut, even though growth is set to slow over the next year or so. It suggests that rates need to remain steady to ensure that inflation remains on target. In comparison to the EU and the US, the UK’s inflation rate has been tracking above the BOE’s target in recent months, which gives the Bank little wiggle room for rates. Financial markets don’t agree with the BOE’s neutral stance on rates; they are pricing in a more than 50% chance of a cut in rates by the end of the year. The fact that the BOE backed away from promising rate cuts at today’s press conference, could be one reason why the pound hasn’t fallen below the $1.21 handle, yet. 

Why the outlook for sterling remains bleak 

While this may support the pound in the very short term, the outlook for sterling remains bleak. The BOE governor Mark Carney said that the pound could fall to a record low on the back of a no-deal Brexit. GBP has fallen nearly 7% on a trade-weighted basis this year, and is more than 7% lower vs. the USD, and more than 10% lower vs. the JPY. The pound is one of the most unloved currencies of 2019, and this week’s performance suggests that there could be worse to come if the UK continues to hurtle towards a no-deal Brexit. 

Why things could get messy for the FTSE 100 

Typically, the FTSE 100 has been a winner when the pound slides, but this hasn’t been the case this week. The UK index suffered its worst day in two months on Wednesday, and, surprisingly it wasn’t all because of Brexit.  We believe that the UK index is suffering from three factors aside from Brexit: 1, weaker global corporate earnings for Q2, 2, slowing global growth, 3, the reluctance of the BOE to commit to cutting interest rates even in the face of Brexit uncertainty. This triumvirate of factors may continue to weigh on the FTSE 100 for the medium term. Although the technical factors suggest that the FTSE 100 is still a buy, it may have to decline further before it attracts bargain hunters. Key support lies at 7,500 and then 7,385. 

Every cloud has a silver lining… 

Overall, the pound remains blighted by Brexit, the Bank of England is gloomy about the prospects for the UK economy but won’t do anything to help soften the blow from leaving the EU, and UK stocks are suffering from global factors that are weighing on earnings. This is not a good time to own UK assets. However, there is a caveat, if there is even the slightest hint that Boris and co. could find middle ground with the EU and broker a deal, then we would expect the pound and the FTSE 100 to soar, taking out bears and GBP naysayers. Thus, it could be a volatile road to the 31stOctober, and although the speed of the decline in the pound doesn’t appear to be slowing, it would be wise to remember that currencies don’t go down in a straight line for long.