Currency analysts at DeutscheBank argue that the UK has moved on from the crisis phase seen in late September and the pound has started to trade like a normal currency.

Sterling will therefore move in line with conventional factors including yields and the current account deficit.

While the bank believes that an exit from life support will be positive for sterling, it believes that fundamentals keep sterling vulnerable.

According to Deutsche, “the UK’s external financing needs remain large and real yields at current market pricing are still too low relative to other major currencies, which, all other things being equal, leaves a likely downward bias for the pound.”

The bank adds: “We maintain short positions, targeting 1.08 for cable by year-end and 0.88 for EURGBP.” (1.14 for GBP/EUR).

The UK current account remains vulnerable

DeutscheBank is expressing continued concern over the UK current account situation and is reviewing the latest forecasts following the dramatic events of the past few weeks.

The bank expects developments in the energy market to be a significant net positive as prices fall, while a review of energy support packages should curb demand to some extent.

Sterling losses should help support export earnings, while fiscal tightening will also restrain domestic demand.

Deutsche expects a net improvement but doubts it will be enough to turn the tide for sterling: ‘Overall, the recent news flow has been more positive for the current account, but this is unlikely to stop external deficits remaining larger than usual and larger than those of other developed markets in the coming quarters’.

With sterling trading as a more ‘normal’ currency, Deutsche looks at the overall level of real interest rates for G10 currencies. The bank believes that real yields are unlikely to be attractive enough to support sterling.

According to the bank, “the UK’s external financing needs remain large and real yields at current market pricing remain too low relative to other major currencies, which, all other things being equal, leaves a likely bias towards a weaker pound.”

Real yields are unattractive and a dovish stance from the Bank of England is likely

Deutsche believes that given current market prices, a meaningful sterling rally would require the MPC to raise prime rates to at least 5%.

Therefore, the situation for the pound could change if the Bank of England decides on a more aggressive monetary policy stance.

We believe the risks are skewed towards a dovish disappointment from the Bank of England this week – a 75bp rate hike is likely, but one that would emphasize downside risks to growth and implicitly put market prices off.

The Bank does see scope for inflows into equities on a valuation basis, and also believes that the UK risk premium has fallen to some extent following the political and tax changes of the last two weeks.

However, he does not believe that the improvements have been sufficient to turn the tide for sterling.

Sterling is also closely correlated with risk conditions, and tighter financial conditions tend to increase the pound’s vulnerability.