In late May, I wrote a report entitled “Is the British Economy Slowing or Stagflating?” in which I examined how the British Pound’s strength, in particular against the U.S. Dollar, might have been unwarranted. In the nearly four months since then, the GBP/USD has depreciated from 1.6473 to 1.6100, at the time this report was written. The pair has traded in a more exaggerated range this year, hitting a high of 1.6745 in April and falling as far as 1.5207 in early October.

Despite signs of a ‘soft’ landing in China and stronger growth in the United States, the British economy continues to lag behind and looks susceptible to further weakness ahead. Could the recent rally in higher yielding and risk-correlated assets – a shift away from the U.S. Dollar and consequently into the Sterling – actually damage recovery hopes for the United Kingdom?

U.K. Growth Rate (QoQ): 2Q 2008 to Present

Slowing_British_Economy_Weighing_on_Sterling_body_Chart_7.png, Slowing British Economy Weighing on Sterling

Source: Bloomberg

Little positive data has emerged over the past five months for the British economy. The Office for National Statistics released its final reading of second quarter growth on October 5, which showed that growth was a miniscule 0.1 percent on a quarterly basis, while an equally disparaging 0.6 percent on a yearly basis in the second quarter of 2011. The figures are even more discouraging considering other advanced economies, such as China and the Euro-zone, anchored by Germany, are slowing as well. A global slowdown in growth will only further weigh on the British economy.

Exports fell during the second quarter, down 1.3 percent, even as the Sterling was weaker across the board: the Franc rose10.32 percent against the Sterling; the Euro gained2.23 percent against the British currency; and the U.S. Dollar was slightly stronger, up 0.23 percent. The other components of the recent growth reading were hardly encouraging: consumer spending dropped by 0.8 percent in the second quarter, while investment rebounded slightly, up 3.8 percent year-over-year.

U.K. Inflation Rate: July 2008 to Present

Slowing_British_Economy_Weighing_on_Sterling_body_Chart_8.png, Slowing British Economy Weighing on Sterling

Source: Bloomberg

Other health barometers of the British economy suggest that growth is likely to slow further in the future. Inflation is now at a 5.2 percent clip as per the most recent reading in September, above the 4.9 percent predicted rate. Recent output data has shown signs of deterioration as well, with industrial production falling by 1.0 percent in August, year-over-year, and manufacturing data falling short of expectations, down to 1.5 percent from 2.6 percent, year-over-year, in August.

GBP-based Pairs: May 2011 to Present

Slowing_British_Economy_Weighing_on_Sterling_body_Chart_1.png, Slowing British Economy Weighing on Sterling

Source: Bloomberg

As I noted back in May, “it is looking increasingly likely that the Bank of England will be keeping rates on hold for some time, in order to stoke growth.” This has been the policy route Bank of England officials have taken, though the methods enacted have proved fruitless thus far; growth remains tepid, inflation pressures continue rises all the while the labor market continues to drag on the economy.

A weaker Sterling might be what the British economy needs, however. By further boosting exports, further investment could enter the country in order to help manufacturers meet foreign demand for British goods. As the economy continues to slow, and inflation remains high, the outlook for the British economy does indeed, as the Bank of England’s Dale noted earlier this year, look “relatively bleak.” If the Bank of England does leave rates low for a continued period and chooses to expand its quantitative easing program further, the Sterling would likely continue to sink further against the safe havens, the Japanese Yen and the U.S. Dollar.

--- Written by Christopher Vecchio, Currency Analyst

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