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Lloyds Bank says pound sterling's resilience against the euro is unlikely to last, warning that the UK economy faces an increasingly difficult mix of slowing growth and persistent inflation.
“Sterling has continued to prove resilient in the face of external threats,” the bank says, pointing to stronger-than-expected economic data and a sharp repricing in UK interest rate expectations following the Iran-driven energy shock.
The call is made in the bank's monthly FX strategy overview that says a shift in rate expectations has supported the pound in recent months by increasing the cost of betting against the currency.
But strategist Nick Kennedy doubts the backdrop can hold.
"The tightening of financial conditions is likely to slow the economy over the remainder of Q2, the inflation shock adding to that hit to disposable incomes,” he says.
Economists at Lloyds think the Bank of England remains far less committed to tightening policy than peers such as the ECB, Norges Bank and Reserve Bank of Australia, despite acknowledging scenarios where rates may need to rise.
“A weak labour market and decelerating wage growth might reduce second round risks, but that also means these conditions ought to push the economy towards stagflation,” says Kennedy.
That combination leaves strategists at the bank favouring short sterling positions against the euro, Norwegian krone and Australian dollar.
The euro can outperform the pound thanks to the eurozone economy's ongoing resilience in the face of the energy shock caused by the Iran war.
“The region has a solid labour market and a constructive fiscal and investment story,” the report, which adds that the ECB commands more credibility in confronting inflation risks.
“Inflation is starting from a low level and monetary policy is at neutral; a couple of hikes would be manageable," says Kennedy.
The contrast leaves Lloyds arguing that sterling’s current support from interest rate markets may prove increasingly difficult to sustain against the euro in the months ahead.
Consensus projections for the next four quarters, compiled from leading investment banks.
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