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UK Political Turmoil Keeps Pound Under Downside Pressure

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(Bloomberg) --

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The pound’s double-digit slump against the dollar this year may not be over yet amid pressure on the currency from a mix of domestic and global concerns.

Sterling fell to a fresh two-year low of $1.1876 on Wednesday, extending a drop of about 12% against the dollar this year. That followed the resignations of multiple members of Prime Minister Boris Johnson’s government, including his Chancellor of the Exchequer Rishi Sunak. It was down 0.1% to $1.1930 as of 2:48 p.m. London time.

Global risk sentiment, recession worries and Bank of England policy remain key drivers for the currency. Domestically, one key focus now is the future of fiscal policy and the possibility of tax cuts under new Chancellor Nadhim Zahawi, who was appointed late Tuesday after Sunak unexpectedly quit. But even a support package to help consumers through the country’s cost-of-living crisis might only have a limited upside pound impact.

“Will they do anything to cut taxes? I don’t think that is still enough to solve the problem of sterling,” said Jordan Rochester, a strategist at Nomura International Plc. “We might see some efforts to lower fuel taxes, VAT, corporation taxes. But the bigger problem is a global one. We’re in a natural gas crisis.”

Nomura is targeting a drop to $1.15 by the end of the month, before falling further toward the $1.10 level by the end of September. That would surpass the lows plumbed in the depths of the pandemic crisis, taking it to levels not seen since the 1980s.

Options traders are also positioned for further losses for sterling. Only during tail-risk episodes, such as the Brexit referendum and the market turmoil in March 2020, has demand for low-probability bearish pound options been greater in the past decade. The spread between so-called 25-delta and 10-delta cable puts shows that investors are willing to pay a relatively high price to hedge against a large drop in the pound.

Johnson Vows to ‘Keep Going’ as Rebel Tories Plot Next Move

While the BOE is raising interest rates to try to tame rampant price growth that’s taken hold, its steps have so far been more timid than those of the Federal Reserve, another reason the pound is losing ground to the dollar. That could change however, with BOE Chief Economist Huw Pill saying Wednesday that he’s prepared to tighten at a faster pace if needed.

“The UK economy faces one of the worst trade-offs between growth and inflation across developed markets,” said Hugh Gimber, at J.P. Morgan Asset Management. “This puts the Bank of England in a real bind. It means you can’t guarantee that rate hikes will be trusted as a positive for the pound, and the political uncertainty over the past 24 hours only exacerbates that downside risk.”

The uncertainty on the pace of further rate hikes saw UK bonds rally Wednesday, sending 10-year yields sliding below 2% for the first time since May, less than three weeks after rising to an eight-year high.

But there’s no ignoring the global factors, particularly the impact of energy supplies if Russia cuts off gas to Europe. Germany’s top power grid regulator has warned that there’s a question over whether planned summer maintenance on the Nord Stream 1 gas pipeline “will turn into a longer-lasting political maintenance.”

If that happens, “we’ll see very strong dollar strength, we’ll see credit risks rise, and that would push sterling even lower,” Rochester said.

(Updates Nomura call on pound)

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