The pound falls to three-year low: Time to fear a sterling crisis?

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The three-year low of the pound against the dollar has sparked concerns of a looming sterling crisis, although Capital Economics argues it is too soon to write off the currency.

Sterling has weakened from $1.57 in mid-June after the Federal Reserve indicated that it would be willing to slow the pace of its $85bn-a-month bond-buying programme if the US economy continues to strengthen.

The currency’s decline was exacerbated by the surprise comment from the Bank of England that market expectations of UK interest rates had risen too far since the Fed’s suggestion, adding to evidence that the Bank plans to keep rates at historic lows for the foreseeable future.

Yesterday, the pound fell to $1.4812, its lowest since June 2010, after official numbers showed the UK manufacturing and industrial sectors failed to grow in May and cast doubt on the strengthen of the country’s recovery. This morning, the cable has risen to around the $1.4899 mark.

Capital Economics chief global economist Julian Jessop says the apparent divergence in the paths of monetary policy in the UK and US has the potential to “hit sterling hard” and says it is “understandable” that the markets are worrying about the pound.

“However, while the relative prospects for monetary policy in the US may continue to support the dollar, we don’t expect any further falls in the pound to be large or sustained. What’s more, sterling looks set to strengthen against both the euro and the yen,” Jessop adds.

The brightening outlook for the UK economy is likely to add to sterling’s strength in the medium term. Recent UK economic indicators have been on an improving trend and the International Monetary Fund yesteday lifted its 2013 growth forecast for the country from 0.7 per cent to 0.9 per cent.

In addition, both the Fed and the Bank are expected to keep monetary policy loose for the coming years. The Fed is not likely to increase interest rates until 2015 even if it does start to taper QE, Jessop notes, while the Bank’s base rate is expected to stay at 0.5 per cent until 2016 at least.

The macroeconomic forecasting consultancy also points out that the bulk of sterling’s slide against the dollar is a result of the US currency’s broad-based strength rather than specific weakness in the pound. The euro is likely to have further downside, it adds, while the yen will probably weaken more due to the government’s reflationary policies.

Jessop concludes: “The upshot is that, while acknowledging the downside risks, we are leaving our end-2013 forecast for sterling at $1.50 and maintaining it at this level thereafter.”