UBS expects sterling to head lower

GBP has been in a currency “sweet spot” over the last several years. Europe, the UK’s largest trading partner, has been growing robustly, as has the financial sector in the UK. With City of London bonuses high and new immigrants moving in, demand for housing at all levels of the income scale surged, causing real estate prices to skyrocket.

These factors pushed up inflation, prompting the Bank of England (BoE) to hike rates to 5.75%, which was reduced for the first time last week. High interest rates have not always translated into an appreciating currency, but the last few years have been dominated by carry trading, and the GBP has offered attractive interest rates.

GBP has benefited from inflows from foreign residents, especially from the Middle

East, seeking to diversify out of the USD. What are the risks for the GBP? First, as the economy is quite dependent on the financial sector, the slowdown could have national implications. Second, housing and real estate investment have begun to slow and look set to continue to do so. Third, with the continent likely to decelerate in 2008, this will have consequences for the UK real economy. All of these factors will prompt the BoE to cut rates – UBS estimate a total of 75 basis points in 2008 – removing much of the yield allure of the GBP.

Additionally, carry trading is under stress across the board, so it will be much harder to exploit any outstanding interest rate advantage.

GBP has already lost quite a lot of ground on a trade-weighted basis, but it remains lofty.

Certain economic data out of the UK, such as GDP and the industrial sector, have yet to show signs of softening. EURGBP has already been just a whisker away from its 2003 high, hitting 0.7213. GBPCHF and GBPJPY remain elevated but have come off their highs. The persistently high GBPUSD owes much to USD weakness. “As we expect the USD to recover, the confluence of factors make for potentially sharp downward moves in cable. We think the risk to the GBP is asymmetrical on the downside, including against EUR,” writes  Katherine Klingensmith in the latest edition of UBS Investors Guide.