Fiscal recovery is a matter of timing

Oct 14 2009 by Andrew Miller, The Journal

STERLING has enjoyed a strong recovery since March of this year, supported by the marked improvement in investor risk appetite and the pickup in the global economy.

But, in recent months, the currency has been under pressure following persistently "dovish" actions and commentary from the Bank of England.

Together, these have indicated that interest rates and monetary policy in general in the UK could remain accommodative for some time.

Given this backdrop, we judge that the outcomes and timing of monetary and fiscal policymakers' decisions will substantially affect the outlook for sterling in both the short term (up to six months) and the long term (over the next 12 months and beyond).

In our view, there are four main scenarios for monetary and fiscal policy, all of which have implications for sterling.

The first scenario is one in which monetary policy and fiscal policy are both tightened quickly.

We judge this combination to be supportive for sterling in both the short term and long term, as interest rates rise and fiscal concerns (and specifically worries about ballooning levels of government debt) abate.

But a very aggressive fiscal tightening, such as a significant increase in taxation levels, might have a substantial effect on the UK economy's recovery, or could even derail it.

The second scenario is one in which monetary policy is tightened quickly but fiscal policy is slow to be tightened. Such a scenario would be supportive for sterling in the short term, while uncertainty around whether fiscal tightening would be aggressive enough to prevent fiscal concerns could weigh on the currency in the longer term.

The third scenario is one in which monetary policy is slow to be tightened but fiscal policy is tightened quickly.

We judge that loose monetary policy would keep sterling weak in the short term, but that it should strengthen in the longer term as the economy recovers and fiscal worries abate.

The fourth - and final - scenario is one where both monetary policy and fiscal policy are slow to be tightened.

This would be the most negative of the four scenarios, as it would be likely to cause sterling to be kept under pressure in the short term and would also cause weakness in the longer term as investors could lose confidence in the sustainability of the UK's fiscal position.

In terms of its valuation, sterling currently looks cheap, particularly against the euro, which has been supported by positive economic data thanks to both France and Germany registering some modest economic growth in the second quarter.

The weakness of the dollar has also helped the euro in recent months. However, although the euro is likely to remain supported over next six months, we expect it to weaken thereafter, particularly as rates of GDP growth in the euro area are likely to look unimpressive in a global context once the economic recovery begins to takes hold.

In all, we would expect sterling to appreciate substantially against the euro in all scenarios except the "worst case" - i.e. one where both monetary and fiscal policies are slow to be tightened and investors begin to doubt whether the country's finances can be returned to a more even keel.

Andrew Miller is regional office head of Barclays Wealth in Newcastle