(Bloomberg) -- Despite the current reprieve, sterling and bonds remain at risk from the UK’s significant need for foreign capital.

Not since the 1970s has balance-of-payments data been so important for markets. The UK’s wide current-account deficit has been a long-standing risk for the country. In times of plenty, it could safely be ignored, and willing strangers easily found to fund it. But when inflation is in double digits, growth is slowing, the dollar is strong and the government decides to detonate its fiscal credibility with inflation-fueling tax cuts, it becomes of deep import.

The data for the second quarter, released today, showed a modest improvement, with the deficit narrowing to 5.3% of gross domestic product, from 6.1% the previous quarter. However, quarterly numbers are noisy, and on a rolling one-year basis, the direction of the deficit is still up, rising to 4.7% of GDP from 4.3%.

Current-account deficits can be closed in a good way and a bad way. The good way is an increase in exports that is not to the detriment of the domestic economy. The bad way is when the adjustment is forced upon a country, as is happening in the UK.

In these times, domestic demand has to fall, leading to a decline in imports. But in the UK’s case, that adjustment has barely begun yet. Imports have been rising due to the increased price of energy. But if the deficit is to narrow, it is almost guaranteed that most of adjustment will come from a painful fall in imports.

The deterioration in the trade balance in recent years can be seen in the breakdown between goods and services. The UK has long been a buyer of goods from abroad on the national credit card, but mitigated by a robust services surplus. The deficit in goods trade has gotten worse since the UK left the European Union, while the surplus in services has stagnated, leading to an overall worsening in the trade deficit.

None of this is good for sterling. Despite a bounce this week on speculation the UK government will have to reverse its tax-cutting package (so far it is refusing to budge), a widening current-account deficit implies greater need for foreign capital, which means yields and the pound must adjust until the net flow of capital returns to balance. Weaker bonds and sterling remain a likelihood until that level is found.

  • NOTE: Simon White is a macro strategist for Bloomberg’s Markets Live blog. The observations he makes are his own and not intended as investment advice. For more markets commentary, see the MLIV blog

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