Weakening pound: what does it mean for UK interest rates and UK assets

Falls in the value of sterling and UK gilts will have knock-on effects across many aspects of the UK economy and markets.

27/09/2022
Sterling_decline

The pound temporarily hit an all-time low against the US dollar of $1.035 on Monday (26 September). This was partly on the back of concerns about the new chancellor of the exchequer Kwasi Kwarteng's ‘mini budget’ (23 September), but follows a summer of political uncertainty after the resignation of former prime minister Boris Johnson.

The same concerns which have contribution to weakness in the currency have also been reflected in the UK bond market, where prices of UK-issued bonds (or gilts) have also fallen sharply, pushing up yields. Again, these moves should be seen in the context of broader developments, which have weighed on bond prices across many developed countries this year.  

But what do these developments mean for the UK economy and asset markets?

The fixed income view

"Investor confidence has clearly been shaken and a lot of negative news has quickly been priced into UK assets," said Paul Grainger, Head of Global Fixed Income and Currency, Schroders.

"The gilt market is now offering the best valuations for many years. However, it is still too early to be buying gilts at this stage, given the lack of visibility of a clear and credible fiscal plan, and uncertainty about how the Bank of England will react.

"The other part of the equation is the currency. The loss of confidence and unfunded nature of the plan has caused sterling to sell off significantly. Many market commentators are calling for it to go to parity, or lower, against the US dollar.

"On the fixed income team we have had a negative view on sterling for most of the year, reflecting broader concerns about the UK economy.

"Uncertainty is likely to remain high. The government and Bank of England need to come up with credible medium-term plans that give markets confidence over inflation, growth and the fiscal dynamic. If this happens, then UK fixed income will be an attractive place to allocate capital, as will the currency."

The multi-asset view

“It’s very tempting to start thinking about buying up UK assets as they have cheapened a great deal” says Remi Olu-Pitan, Head of Multi-Asset Growth and Income Strategies, Schroders. “But the combination of fiscal spending that’s unfunded or funded by higher borrowing is a concern and history suggests it doesn’t end well.

“At the moment investors need more confidence, and that needs to come from both the Bank of England and the government to allay a lot of those fears. Until then, investors will demand a higher risk premium for owning UK assets, and that has to come either via sterling weakening further or government bond yields rising further. So things might need to get even cheaper first.

“Some credibility has been lost and something needs to happen for international investors to get the confidence to dip their toe into these cheap assets.”

09-27Swap_chart

Consequences for UK interest rates

Azad Zangana, Senior European Economist and Strategist, Schroders says:

“There is a concern the Bank won’t follow through and do what the market is telling it to do. That is, to raise rates to 5.25% by the middle of next year and 5.5% the end of 2023. International buyers of gilts are demanding higher rates to compensate them for what they now see as a greater risk of lending to the government.

“If it can, I suspect the Bank will avoid intervening with emergency rate rises given its past experiences of currency intervention such as Black Wednesday in 1992, when the UK was forced to withdraw from the European Exchange Rate Mechanism following a collapse in sterling. The Bank can, however, put out more hawkish statements – hinting at more rate rises - between now and the next Monetary Policy Committee in November.”

Consequences for UK companies

While domestic investors are not directly impacted by the decline in sterling, they are asking to what extent currency weakness translates into higher import and borrowing costs for the UK companies in which they’re invested.

The UK imports many goods, and in particular energy priced in dollars (the dollar has been very strong this year in addition to sterling’s weakness). Companies also borrow on international bond markets in dollars and euros.

Sue Noffke, Head of UK Equities, Schroders said: “We have to consider currency, interest rates, bond yields and economic growth all together. The government’s energy packages should cushion the impact on households and businesses and reduce the inflation rate from what it would have been without these interventions.

“These interventions and the cancellation of corporate tax increases due to start in April 2023 means UK GDP should see an uplift, translating into earnings upgrades for companies which don’t have borrowing or currency related input cost issues. Although this might well exclude retail and property companies which may not benefit due to the falling pound in the case of the former and rising interest rates in the latter.

“There are lags built into the system which could help to soften the immediate blow. Companies importing goods, whether finished product such as consumer electronics, clothes and food, for instance, or components including vehicle parts for assembly within the UK, say, have financial methods of shielding themselves. In the short term adverse movements in exchange rates can be offset, namely by currency hedging.

“Ultimately, however, all of these challenges will roll over at some point and we remain focussed on companies’ long-term fundamental prospects.

“Meanwhile quoted companies, and in particular the constituents of the FTSE 100, are mainly overseas earners, and so their profits, dividends, revenues and valuations could all potentially benefit from the fall in the pound.”

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