Queen’s Speech is the Next Major Risk to the British Pound Outlook

The pound sterling is underpinned by a strong economic growth profile which should ensure near-term strength continues, the longer-term outlook is however less than certain.

The outlook for pound sterling turned positive once again after the May General Election delivered a stable Government. This allows GBP to trade in line with the positive fundamentals underlying the UK economy. Despite a significant rally following the release of the election results many in the currency markets believe there could be plenty more near-term upside in GBP.

Technical studies of both the pound to euro conversion and pound to dollar conversion confirm these currency pairs are looking well positioned to deliver gains.

Something we have little insight however is the longer-term picture, that timeframe that takes in year-end and beyond. Institutional researchers at Morgan Stanley have shed some light on the longer-term, and the picture is certainly less rosy than nearer-dated timeframes.

Risks to Sterling = Political in Nature

The UK economy is exposed to a reliance on foreign funding, and any drying up of global liquidity is forecast to be a key risk to GBP strength in coming months and even years. As the global economy continues to leave the global financial crisis in its wake, the chances of such a scenario occurring are increasingly unlikely. Indeed, one recent report suggests US institutional investors are looking at making further significant investments in the UK over coming quarters.

The last two risks to the otherwise positive GBP outlook are political in nature argue investment bank Morgan Stanley in a May FX note to clients.

“Specifically, the Conservative Party looks set to potentially impose large fiscal prudence on the government. Should a repeat of the last administration play out, where austerity is front-loaded, this could put significant downward pressure on the fragile UK recovery,” says analyst Hans Redeker.

In addition, Governor Carney noted this week that “the most important stance of policy in general, for monetary policy over the monetary policy horizon, is the stance of fiscal policy. We take the stance of fiscal policy as given and then we optimise monetary policy around that”.

“As such this scenario, all else equal, would likely result in a flattening of the UK money market curve and reverse recent GBP gains. The Queen’s speech on May 27 is thus a key risk event to watch for the sterling outlook,” says Redeker.

Longer-Term: EU Referendum to Weigh

Looking beyond the ‘austerity’ threat to the pound sterling, the third key risk for the GBP outlook is the potential for a referendum in the UK regarding its membership in the EU over the next two years.

“If the perceived risk of a ‘Brexit’ grows, foreign business investment could slow over concerns that the UK will lose full access to the European market. A decline in FDI would require less stable portfolio flows and potentially a weaker GBP to finance the large current account deficit,” says Redeker.

That said, the referendum is at least a few quarters away and therefore not likely to weigh on GBP near-term.

Moreover, recent polls suggest a majority of the British population support staying within the EU. The direction of fiscal policy is a more immediate concern than ‘Brexit’ risks in the view of Morgan Stanley.

All eyes then turn to the Queen's speech on the 27th of May for guidance on how the Government's fiscal programme could impact economic growth. Morgan Stanley have pointed out that the restriction of money into the economy via Government spending could slow the recovery. However, there is also the argument to be made the economic credibility is of high importance to investors, and the laying out of a credible agenda could also be GBP positive.

It is all therefore all about hitting the right balance. We would add that the emergency budget scheduled for June the 8th will add the real details of the fiscal agenda, and see this as being of equal risk to sterling as the Queen's Speech.