In the UK, falling wholesale energy prices may be a bigger deal for sterling than gilts. They would have an immediate impact on the UK’s balance of payments and, in turn, sterling. In fact, they might have an even bigger impact on sterling than monetary policy does in the current environment. That’s because markets judge the valuation of the pound by considering how a large and persistent current account deficit is to be funded by net foreign capital flows, and at what exchange rate.
On balance, we think the downside risks to sterling are exaggerated, and that the pound is likely to rise moderately against the US dollar over the next 12 months as the dollar slips back from its cyclical highs and the Fed becomes less hawkish.
In terms of the short-term outlook for economic growth and government borrowing requirements, we don’t think continued falls in energy prices will have a major impact. However, they will flatten the distribution of risks around housing market weakness, growth and borrowing, which could drive a reassessment of the risk premium in the eyes of markets.
While the outlook for the UK economy is still relatively poor, we think pessimism about the UK’s growth outlook is overdone, and that improving sentiment as gas prices fall should support the pound. At the very least, the risk that growth is much weaker than expected seems to have abated. Recent trends point to a move higher for sterling against the euro.
In Europe, business sentiment surveys and data point to an imminent improvement in German economic activity, probably driven by lower gas prices and the support being provided to firms and businesses with their energy bills. This also reflects more favourable inflation dynamics, which could result in easier ECB policy from here. A more normal mix of demand and inflation is also likely to support the euro against the US dollar.
It’s still possible that the ECB may take advantage of reduced budget pressure to accelerate its quantitative tightening process or spend the money it has saved on energy support measures in other areas such as social projects or the energy transition.