Sterling's election-led bounce breaks developing spiral

Thu May 4, 2017 3:56am EDT
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By Jamie McGeever

LONDON (Reuters) - The lift to sterling given by the prospect of a snap British election next month has, at least temporarily, broken a vicious circle of rapidly rising inflation that threatened to further undermine the economy and paint the central bank into a corner.

The currency's steep fall since June's Brexit referendum has aggravated inflation to 2.3 percent, above the Bank of England's 2 percent target, risking a drain on consumers' real spending power while tying the Bank of England's hands if further monetary easing were needed.

The pound has traded in a range of roughly $1.20 to $1.27 to the dollar for the past six months and many analysts said they thought it was heading back towards the bottom of that range or even lower due to fears the two-year EU exit negotiating process would bring a sharp break with the bloc.

British bond yields had been climbing on the inflation picture and the conundrum that would pose for policymakers, driving up the country's borrowing costs.

But after the election announcement on April 18, sterling rose sharply, breaking out of the top of the range to a seven-month high close to $1.30, due to indications from opinion polls that it would result in a bigger majority for Prime Minister Theresa May's ruling Conservatives.

Investors took the view that it would also boost the number of Conservatives seeking a “softer” Brexit, in which Britain keep some kind of preferential access to the EU single market rather than cutting all ties as some in the party advocate.

Few people think the pound will rise much further, but if it levels out, it should help tame inflation and ease the strain on consumers, whose spending accounts for about two thirds of economic output, breaking the "stagflationary" spiral of higher inflation and lower growth.

The turnaround has been accompanied by a reversal in bonds. The benchmark 10-year yield recently hit a six-month low close to 1 percent, having topped 1.50 percent in January.   Continued...

U.S. dollar and British pound notes are seen in this November 7, 2016 picture illustration. Picture taken November 7. REUTERS/Dado Ruvic/Illustration