Once Unthinkable, Parity For Sterling Is On The Horizon

(Bloomberg) -- The prospect of the pound hitting parity versus the dollar is becoming ever less outlandish. The looming threat of a recession, acute dependence on foreign capital, soaring debt costs, and the rising likelihood the Bank of England’s independence will be circumscribed are bad news for UK assets, and leave bonds and the currency in an increasingly precarious position.  

UK-bashing has become something of a national pastime, but it is hard to come to an optimistic outlook by taking a dispassionate look at the data. There is no point in mincing words: the situation looks dire.

The UK is facing the same challenges as other countries, but compounded by its own unique set of problems. It’s seen a rise in inflation after the sugar rush of pandemic policies, followed by the highest interest-rate rises for many years. Growth is set to slow much more in the coming months, based on the unequivocal message from collapsing leading indicators; it won’t be long before the UK is flirting with a recession.

The UK’s problems are exacerbated by a potential “single-point of fracture” in its gaping current-account deficit. The country has long run a large current-account deficit that continues to widen. The goods deficit is collapsing more than the services surplus is improving. Furthermore, the primary-income balance is now structurally in deficit, as the UK’s ability to command a premium on what it receives from overseas assets compared to what it pays on assets held abroad has evaporated. Blame Brexit or not, but the data don’t lie.

The budget deficit is large too, with approximately 25% of outstanding gilts owned by foreigners. Moreover, the UK faces a similar challenge to other European countries from spiraling energy costs that will likely have to be subsidized in some way by the Treasury. The UK has no direct exposure to Russian gas, but remains exposed to indirect effects given its energy dependence on other countries of around 35%.

Add in the current-account deficit, and the UK has one of the largest twin deficits in the world. At 11.1% of gross domestic product, that’s an ocean of foreign capital required to keep the wheels turning.

In good times this is a less of a problem. But when growth is about to slow sharply, access to your largest export market is fraught with new challenges, and your currency is in steady decline as a reserve asset, the kindness of strangers begins to look less like an act of benevolence than a prerequisite for survival.

If this wasn’t enough, the UK government’s debt bill could soon hit nosebleed levels. For reasons that probably made sense to someone when inflation was in a low and stable regime, close to 24% of UK government debt issued is inflation-linked. This means if some of the top-end forecasts are realized, the UK could end up paying close to 3% of GDP next year on coupons for inflation-linked debt alone. 

Nonetheless, debt markets are becoming increasingly wary of the UK’s likely next prime minister. Liz Truss, who is strongly predicted to become PM on Sept. 5, has advocated reviewing the BOE’s mandate on setting interest rates. 

Interfering with the delicate pact that has evolved over the last several decades between more transparent central banks and the bond market would be laden with risks at the best of times. But when growth is about to slump, debt costs are rocketing, and the need for foreign capital enormous, it is taking the pin out of the grenade. 

The UK may avoid this fate, of course, but markets are increasingly taking a different view. 

Sterling versus the dollar is the world’s oldest traded currency pair, going back 250 years, but the implied probability of it hitting all-time lows of 1.05 by the end of the year is now 1-in-7. And, despite being in the realms of fantasy at the beginning of this year, even the 1-in-32 odds of sterling breaching the Rubicon of parity with the dollar now look like a reasonable bet. We have been warned.

• NOTE: Simon White writes for Bloomberg’s Markets Live blog. The observations he makes are his own and are not intended as investment advice. For more markets commentary, see the MLIV blog

(Updates to add UK’s energy dependence in fifth paragraph. An earlier version corrected to say UK in first deck headline.)

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