Unfavorable Outlook for the British Pound

[Redator]

The past week brought a wealth of macroeconomic data from the United Kingdom, which, at first glance, seemed supportive of a renewed rally in the pound. The labor market report revealed some signs of weakness, particularly a slower pace of job creation compared to the previous month. However, the fact that wage growth remains stubbornly high is a strong inflationary factor. Elevated inflation, in turn, signals that the Bank of England will not be in a hurry to cut interest rates, allowing UK yields to remain relatively attractive.

August GDP figures met expectations, and industrial production outperformed forecasts. Still, the third quarter outlook from the National Institute of Economic and Social Research (NIESR) remains weak, with only modest GDP growth of 0.3% expected.

On Tuesday, the UK's consumer inflation report for September will be released. Last month, NIESR noted a very high probability that inflation would remain above 3% for the next 12 months. Current projections anticipate that core inflation will rise from 3.6% to 3.7% year-over-year, and headline inflation from 3.8% to 4.0%. In the past, such expectations alone would have been enough to support sterling strength, but broader market dynamics have shifted. Other global factors now suggest that the U.S. dollar is poised for renewed appreciation, and the pound is likely to weaken in line with broader risk sentiment.

Another underappreciated but significant pressure point for the pound lies in the UK bond market. While the yield on 10-year Gilts stands around 4.5%, a large portion of that yield reflects the "term premium"—the additional return investors demand for holding long-term debt, which is directly linked to fiscal sustainability risks. With UK public debt hovering near 100% of GDP and interest payments totaling approximately £90 billion per year, public finances are under clear strain. Under current inflation expectations, the government would need to find an additional 2% of GDP just to stabilize debt levels, according to NIESR. With a budget deficit of about 5% of GDP and weak economic growth, this appears nearly unachievable—driving risk premia even higher.

As a result, the pound is under significant, albeit less obvious, pressure, and demand for sterling is unlikely to grow meaningfully until a clear economic strategy emerges. That clarity depends on a marked improvement in economic activity—something that is improbable at current interest rate levels. Yet, lowering interest rates is off the table as long as inflation expectations remain high.

This self-reinforcing dynamic severely limits foreign investment inflows, so demand for the pound, even amid higher interest rates, is likely to remain weak.

The fair value estimate for GBP is now trending downward away from its long-term average.

Last week, we identified the 1.3140 level as key short-term support, and that target remains valid. The corrective rebound seen in recent days has been shallow and unconvincing. We expect another wave of downward momentum. More clarity will come following the release of the UK and U.S. inflation reports. Until then, the outlook for the pound remains constrained by fiscal concerns, limited growth potential, and deteriorating sentiment.

The material has been provided by InstaForex Company - www.instaforex.com