Sterling enjoyed a brief rally this summer, with a 2% rise against a basket of currencies of the UK’s major trading partners and rose around 9 cents to hover just below the USD $1.60 mark.

Sterling has managed to perform relatively well because of the inherent weaknesses of other economies; the Euro was held back (the Greek economic crisis) and the US dollar has been suffering against every other major economy in the world as it struggles to shake itself out of the effects of recession.

Now the reality of the UK’s economic situation, and in particular the size of the national deficit, is affecting the outlook for sterling.

The Bank of England, the UK’s central bank, is also under pressure to control the country’s inflation rate.  Inflation has been higher than the target rate set by the Bank for 41 of the last 50 months and there is a very real risk of this increasing.  The reason for the potential inflation increase is that the economy is in such a weak state that further stimulus is thought to be required (certainly the Bank of England has been strongly hinting at this).

If further stimulus is required, this will involve the Bank purchasing bonds to inject cash into the economy.  Cash injections will increase the supply of sterling which will decrease its value, i.e. it will be relatively cheaper to buy with overseas currencies.  A secondary effect on this “quantitative easing” will be to fuel increases in inflation, and when inflation rates run high then the currency weakens relative to foreign currencies.

Clearly the Bank is in a difficult position; however this is as nothing compared to the scale of the government budget cuts which have yet to be implemented.  In some instances, government departments are expecting to have 25% of their budgets slashed in an effort to reduce the national deficit.

Government cuts of this magnitude are going to have a negative impact on an already weakened economy, further depressing the valuation of UK assets.  In addition, union unrest over the scale of the public spending cuts, which is going to mean large scale redundancies and job losses in both the public and private sectors, is increasing unease over the future economic outlook of the country.
Either way, the government spending cuts will result in a negative impact on sterling; however the scale of the public deficit is having a “drag” effect on economic recovery.

Summary

The political promises made by the incumbent Conservative government are about to be implemented.  This means enormous cuts in public spending in an effort to cut the very high budget deficit.  Union unrest over job losses and the impact on the overall UK economy is causing deep concern and increasing risk which in turn will depress sterling’s value against other currencies.

Meanwhile, the Bank of England which is tasked with managing inflation and providing economic stimulus is trapped.  Inflation is running higher than the level deemed necessary, however the economy is in a much weakened state and is in need of further stimulus.  Stimulating the economy involves purchasing bonds; this increases money supply as well as the inflation in the economy and further depresses the value of sterling.

The outlook for sterling in the forthcoming year is therefore negative, which means good news for expats repatriating money back to the UK (as you will be able to buy more sterling) but bad news for those taking money out of the country (sterling will buy relatively less foreign currency).