U.K. In Danger Zone As Pound And Gilts Set To Plunge

(Bloomberg) -- The UK is fast becoming the epicenter of the global stagflation crisis, as the Bank of England’s policy-tightening campaign and the soaring cost of living put the world’s fifth-biggest economy on the verge of recession.

It’s about to get even worse, according to a clear majority of market participants in the latest MLIV Pulse survey.

More than two thirds of 191 respondents see the currency tumbling to $1.15, a 6% decline from current levels to lows unseen even in the post-Brexit chaos. Meanwhile a similar proportion expect 10-year gilt yields to climb to 3%. The 10-year Gilt yield was up about 5 basis points at 1.79% as of 8:12 a.m. New York time. The pound was little changed against the dollar at $1.22. 

The gloomy outlook threatens to hamstring policy makers in their bid to combat the economic downturn, while heaping fresh pain onto consumers and businesses already reeling from the fastest inflation in three decades.

While few countries have been left unscathed by the pandemic and its inflationary aftermath, the UK’s decision to leave the European Union has made it more vulnerable, say 80% of MLIV readers. 

As the central bank is forced to tighten policy aggressively, Pulse respondents see 10-year yields gapping higher. All that risks creating a historic cashflow squeeze for British borrowers, just as wavering consumer confidence causes a slowdown in spending. 

A 6% decline in the pound on a trade-weighted basis in the current quarter would likely lift inflation 0.6 percentage point higher than otherwise in the quarters ahead, according to Bloomberg Economics’ SHOK forecasting tool. 

“We’re getting into a more stagflationary environment, where growth is expected to slow sharply but inflation pressures to remain elevated, keeping pressure on the Bank of England to tighten into the slowdown,” said Lee Hardman, a currency strategist at MUFG in London. “That’s a negative mix for the currency.”

UK households are facing the second-worst year on record for real disposable income, according to BOE data going back to 1964. 

Meanwhile, many of the much-touted Brexit benefits have yet to emerge. Trade deals have done little to replace the seamless exchange of goods and services the UK enjoyed with the world’s largest trading bloc. The City of London, which enjoyed more than three decades of near unbroken growth as Europe’s financial hub, must now resort to workarounds to maintain access to the EU. 

When MLIV readers were asked to predict the top three financial centers in the next decade, 92% cited New York, followed by the UK capital at 68%, pointing to a growing split between the two cities that were once neck-and-neck. Shanghai was next with 36%. For those with a glass-half-empty disposition, the results also suggest almost a third of MLIV respondents expect London to lose its status as one of the world’s top financial hubs. 

The costs of Brexit faded into the background when the pandemic hit. A huge wave of government money staved off an immediate reckoning, but this year as the bill for Brexit and Covid starts to emerge the BOE faces a stark balancing act. The monetary authority issued the most gloomy outlook of any major central bank this month, warning Britons to brace for a prolonged period of stagnation or even recession. 

In the view of MLIV readers, its hawkish policy pivot could have been better flagged, with just 16% of respondents rating the BOE the best central bank at setting market expectations. That was ahead of the ECB but far behind the Federal Reserve, which snagged 34% of the vote. Still “they have all been poor” was the clear favorite, suggesting Fed Chair Jerome Powell shouldn’t be patting himself on the back either. 

A drop in the pound to $1.15 would imply retesting the low reached during the height of the pandemic selloff. The currency never fell that far in the tumultuous aftermath of the Brexit referendum, or in any of the subsequent political crises.

Although the dismal outlook is in part a strong dollar story, the mooted threshold is historic. Other than in the March 2020 rout, the only time the pound has traded below $1.15 was in 1985, after US rate hikes boosted the greenback, according to data compiled by Bloomberg going back to 1971. 

Meanwhile, a 3% yield on 10-year gilts would be quite the move given the rate sits at about 1.74% currently -- implying more trouble for indebted borrowers while cooling the red-hot housing market. 

It’s not all bad news for UK money managers, though. Some 58% of MLIV readers see the FTSE 100 continuing to outperform the S&P 500 Index, which is more heavily weighted to interest-rate-sensitive growth stocks. A weaker pound would actually support the export-led UK index. 

More than three quarters of the respondents were based in either Europe or North America, and they disagreed strongly about the relative performance of UK and US assets. While two thirds of those in Europe expect the FTSE 100 to beat the S&P 500, just 44% of respondents in North America agreed. 

• For more markets analysis, see the MLIV blog. For previous surveys, and to subscribe, see NI MLIVPULSE.

(Updates to add market prices in third paragraph)

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