Sterling back in the headlights

The US 'fiscal cliff' deadlock and recurring euro zone sovereign debt crisis diverted attention from sterling for much of last year. The pound's perceived safe-haven status during this period meant it benefited from diversification away from the dollar and euro.

2013 has seen a shift in foreign exchange markets with temporary relief in the euro zone and US shifting the focus back on the UK. From its highs at the start of the year, sterling has fallen 4% versus the euro (to below €1.19) and 3% against the US dollar (to $1.58).

Currency markets don't take kindly to uncertainty. Two key concerns for sterling have arisen. Firstly, markets are increasingly sceptical that the UK will retain its AAA credit rating. Fitch, one of the three main rating agencies, warned recently that a delay in tackling government debt levels poses a risk to the UK's status. December's public sector borrowing figures were worse than expected, suggesting the Office for Budget Responsibility's target could be missed.

The second issue is the move towards an EU referendum, raising concerns that investment will be discouraged if the UK isolates itself from the rest of Europe. Just as the euro zone looks to be coming together to resolve its problems, political risk returns as a threat to sterling.

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Economic conditions are unlikely to provide meaningful support for sterling. Since the onset of the global financial crisis the UK's recovery has lagged behind the US and even the beleaguered euro zone. Continued high levels of public and personal debts remain a headwind to future growth. With both the private and public sector under pressure to repay debts, the Bank of England is expected to keep interest rates low, making sterling less attractive to foreign investors.

Furthermore, the Bank will view a weaker pound favourably, as it can provide a boost to the competiveness of UK exporters. The fact the UK still imports much more annually than it exports, as it has since the mid-1980s, offers a strong case for believing the pound should weaken more over time.

However, it would be easy to become overly pessimistic about the pound's immediate prospects. Sentiment can change very quickly in currency markets and further bouts of uncertainty could be just around the corner for the euro and dollar. In the coming months US Congress must still agree to increase the government's statutory borrowing limit amid continuing political wrangling over how it will tackle its debts over the long term. The euro zone's problems are far from over. Recent optimism over the euro risks complacency over the need to push through the structural reforms required to achieve a lasting solution. Furthermore many expect George Osborne's 20 March Budget to reveal fresh tax rises and spending cuts to try to placate the rating agencies.

The recent movements in exchange rates reflect the shift in sentiment in financial markets away from the pound. In the short term sterling could weaken further having broken through the key psychological levels of €1.20 and $1.60. We can keep you informed of the pound's progress via our free online currency reports. If you need to discuss your foreign exchange requirements, you can speak to one of our currency specialists by calling 0117 311 3257, or emailing us

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