The British pound was the summer success story on FX, making inroads into the dollar while all else declined against the mighty buck. A thriving UK economy, the afterglow of a surprisingly conclusive election victory for David Cameron’s Conservative party and hawkish Bank of England rhetoric conspired to turn all heads towards peacock-strutting sterling.

It’s looking a bit colourless now. Sterling is off 4.5pc against the dollar in the past four weeks, and by more than 6pc against the euro since mid-July.

“The economy looks fine,” says a puzzled Kit Juckes, FX strategist at Société Générale. Wage growth is strong, so is GDP. Meanwhile, he points out, the European Central Bank is under pressure to extend quantitative easing and the Federal Reserve has been ultra-dovish.

“So which of those two do you want to buy against sterling?” Mr Juckes asks. The expectation of a rate rise is one of four possible reasons behind sterling’s stumble. Morgan Stanley has a ‘Mike’ index, which measures the spread between the US and the UK in terms of months to a first rate rise — and it’s widening.

Who’s been plucking away at sterling’s feathers?

Ian Stannard, Morgan Stanley currency strategist, says there is a perception in the market that the BoE won’t go before the Fed in raising rates. But when the Fed goes dovish, the subsequent pushback on UK rate expectations is given a further shove.

“UK expectations get pushed back further than US expectations. It’s a function of UK market sensitivity to rate expectations — you get a bigger moving taking place,” Mr Stannard says.

Second, sterling also tends to weaken more than the dollar and the euro in times of market volatility. Why? It’s got a current account deficit which, though it has narrowed, is still at a near-record high. That deficit relies on global cross-border capital flows.

But when the market is volatile, these flows to countries with a deficit start to dry up, and seek out those currencies with current account surpluses. A haven sterling is not.

The current account deficit is sterling’s ‘Achilles heel’, says Kamal Sharma, G10 strategist at Bank of America Merrill Lynch. “It is no surprise to see the current account surplus currencies (the euro, the Swiss franc, the Japanese yen) all performing well versus sterling.”

Third, UK data and they are not as strong as they once looked. “There is little doubt that British manufacturing has had a poor quarter,” says Jane Foley, senior currency strategist at Rabobank, even though PMI manufacturing data for September showed some signs of stability.

Sterling’s strength was partly to blame. The Confederation of British Industry has been highlighting how export demand has been in decline as the pound rose. A strong sterling and soft commodity prices held back inflation, which is again back to zero.

The hawks have gone quiet, notices Ms Foley. She has pushed back her first BoE rise to August.

On the other hand, says Standard Bank FX strategist Steven Barrow, UK rates are going to be going up long before the ECB raises its rates. So even if there is some sterling weakness around, it will be temporary.

“The trend of euro-sterling should stay down over time, with odd bouts of weakness on the way if UK rate expectations wobble, or eurozone data improve enough to alter QE speculation, or UK politics intervenes,” Mr Barrow says.

Politics is the fourth possible reason. Political risk has weighed on sterling in the recent past, notably in 2014 when the polls pointed to a possible Scottish independence referendum victory.

Sterling has benefited from positive factors this year, says Mr Stannard, but “these are starting to fade”.

Published in Dawn, Business & Finance weekly, October 5th , 2015

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