2016 has begun the way it ended for GBP. In TWI terms, GBP posted only its fourth negative monthly return in December, while the 2.9% drop was the largest decline for that month since the financial crisis. As explained above, we attribute sterling’s decline through end-2015 as a result of the Bank of England’s concerted attempt to break the perceived link between its own policy reaction function that of the Fed’s. The sell-off has been exacerbated in the first two weeks of 2016 against a backdrop of heightened market volatility, exposing sterling’s Achilles Heel of its current account deficit once more. As seen in Chart 3, the rise in the Merrill Lynch Global Financial Stress Index has weighed on the pound in much the same way that it did during August volatility spike which was again sparked by China fears.
For now, and with the policy divergence story taking a backseat to China developments, we expect that GBP price action to continue to be driven by the broader market outlook. The Bank of England’s affirmation of the UK rates market view on lift-off (currently early 2017) provided the initial trigger for the correction in GBP which had built up a head of steam following the decisive general election victory in May 2015. Chart 4 shows that the GBP TWI index has corrected from the strong upward momentum last summer (here defined as a 1.5 standard deviation move in the six-month % change in the GBP TWI). The correction has taken momentum towards the other extreme which hints at some stabilization ahead.
Combined with an oversold technical picture for GBP versus EUR and USD, we doubt that a dovish message is likely to be overly bearish for the pound.
The Bank of England seems comfortable for now with its revised message on the outlook for UK rates against the backdrop of subdued near-term inflationary pressures and waning average earnings growth. UK rates markets are already pricing in a delay to tightening into 2017. China and its implications for the broader markets dominate near-term sentiment but another, potentially more significant risk factor, Brexit, is firmly on investors radar screens. We expect this to become a more important driver for GBP (and particularly FX volatility) once the date of the referendum has been confirmed.
