Why sterling is going 'to hell in a handbag'

published 22 August 2008

European holidays have already become 18% more expensive since last summer. Now shopping in America is becoming less and less of a bargain. Sterling has hit the skids, sliding to an 11-year low on a trade-weighted basis and a 22-month low against the dollar. It has now fallen by almost 7% to around $1.86 since the end of July.

Part of the story is the dollar's broader recovery amid sliding commodity prices and mounting fears over the growth outlook elsewhere. But the Bank of England's gloomy assessment of the economy last week prompted traders to pencil in UK rate cuts sooner than hitherto expected. The focus among global investors is now firmly on growth rather than inflation and "UK growth is falling to pieces", says David Bloom of HSBC. The reduction in the expected gap between American and British interest rates makes the pound less appealing relative to the dollar for global investors seeking high yields.

But "more fundamental forces" are also at work, says Capital Economics. It's been clear for ages that Britain had similar imbalances to America and that sterling thus looked vulnerable to a derating akin to the dollar's. There's a large current-account deficit 3.6% of GDP over the last 12 months worse household debt in relation to disposable income, and an overvalued housing market, which, in contrast to America's, has only just started to plummet. Britain's reliance on financial services also boded ill as the credit crunch kicked in.

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So how far will sterling fall? The sharply-deteriorating economy means sterling is "heading to hell in a handbag", says Bloom, who sees the pound at $1.75 by the end of the year. Trevor Williams of Lloyds TSB sees scope for a fall to $1.50-$1.60 long-term. Near-term losses against the euro may be capped by the fact that the eurozone is also sliding into recession, says Jamie Dunley in The Daily Telegraph. Expect the trade-weighted index to lose "at least another 5%", mostly against the dollar, says Capital Economics. Sterling's adjustment as the economy's imbalances unwind is far from over.