The pound was higher against the US dollar on Monday amid little economic data releases and thin trading. The US dollar fell after Friday’s dovish speech by Fed Chair Jerome Powell. Jerome Powell indicated Friday that the central bank will possibly begin tapering before the end of the year, but a rate hike was not imminent as there is still “much ground to cover” before the economy reaches full employment. At the same time, there could be some risk ahead for the pound, due to renewed Brexit concerns.

Jackson Hole symposium

In his much-anticipated speech at the Jackson Hole symposium, Fed Chair Jerome Powel said that the central bank could start tapering its stimulus programme by the end of the year, easing market fears for a quicker withdrawal of its funding.

The Fed took its benchmark rate down to almost zero and accelerated its quantitative easing programme in an attempt to resuscitate the economy during the early days of the Covid-19 pandemic.

The question of when the Fed will begin to tighten its programme has been the main concern for markets for some time now, and it might remain as Powell avoided to give any definite answers. The Fed is aware that any specific answers could seriously impact the global economy, this is why it has chosen to postpone any reduction of its funding.

“The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test,” Powell said during the summit. He added that inflation is close to the Fed’s 2% target rate, but “we have much ground to cover to reach maximum employment.” Markets reacted positively to Powell’s comments, with major stock indexes rising higher.  

Fed Vice Chairman Richard Clarida also agreed with Powell’s remarks. He explained that tapering could be possible by the end of this year, as long as labour gains continue: “I think that if that materialises, then I would support commencing a reduction in the pace of our purchases later this year,” Clarida noted.

The Fed said that “substantial further progress” will need to be seen before tightening policy. Powell said that in terms of inflation the “test has been met” and that there “has also been clear progress toward maximum employment.” He said that the Fed agreed at the July Federal Open Market Committee meeting that “it could be appropriate to start reducing the pace of asset purchases this year.”

Powell defended the Fed’s policy and decision not to make an “ill-timed policy move” and stated: “Today, with substantial slack remaining in the labour market and the pandemic continuing, such a mistake could be particularly harmful. We know that extended periods of unemployment can mean lasting harm to workers and to the productive capacity of the economy.” Additionally, he stressed that the delta variant “presents a near-term risk” but “the prospects are good for continued progress toward maximum employment.”

Renewed Brexit concerns

The UK government supply chain crisis could have a significant impact on Christmas and create further food shortages over the next year too. Iceland, Nandos, KFC, McDonald’s, and Tesco are among the many businesses that are reporting stock issues as a result of lorry driver shortage due to Brexit. Restaurant chains Nandos and KFC are facing chicken shortages, McDonald’s is finding it difficult to make milkshakes and Iceland is running out of bread and soft drinks. The problem has become noticeable over the summer when social media was flooded with images of empty shelves.

The disruption was then largely blamed on the “”, but businesses have for a long time now warned of a chronic shortage of lorry drivers due to Brexit. Speaking to BBC Radio 4’s Today programme, Iceland managing director Richard Walker said the lack of lorry drivers “is impacting the food supply chain on a daily basis.” “We’ve had deliveries cancelled for the first time since the pandemic began, about 30-40 deliveries a day,” he said.

British Poultry Council chief executive Richard Griffiths said last week that “When you don’t have people, you have a problem - and this is something we are seeing across the whole supply chain. The labour crisis is a Brexit issue,” he said.

Nick Allen of the British Meat Processors Association warned that such shortages will impact on Christmas staples: “We are cutting back and prioritising lines and cutting out on things, so there just won’t be the totals of Christmas favourites like we are used to.”

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If strong domestic data confirm expectations that the UK economy is growing, then the pound could rise higher. According to a recent UK business activity survey, the August Bank holiday weekend is expected to push business revenue higher as more consumers flock to the shops.

Sterling will remain volatile due to global developments and concerns about the spread of the new Covid variant, but UK economic growth and Bank of England policy will also be key drivers of the currency. The release of better-than-expected economic data will offer much needed support to the economy and the pound.

Pound sentiment suppressed due to labour market concerns

Concerns that a labour shortage could impact on the UK’s economic recovery have been expressed in the quarterly survey from the Confederation of British Industry (CBI). A quarterly survey conducted by the CBI from July 29 to Aug. 16, showed that optimism was at minus 17% this month, down from May’s 47% as companies struggled to bounce back after the pandemic. Charlotte Dendy principal economist for the CBI, said on Thursday that “Firms in sectors such as hotels, restaurants and travel do not expect this strength to persist into the next quarter, reflecting the pressure that consumer services firms continue to face.” Labour shortages could weigh on businesses’ investment plans for the next 12 months.

For services businesses, there are added costs and higher wages after the pandemic that they need to resolve, while Brexit has made it more difficult to access talent from the EU. An index tracing the outlook for costs showed that it has reached the higher in two years and is starting to filter through to the prices, with average selling prices rising at the fastest rate since 2019.

Bank of England interest rate hike

The Bank of England is expected to raise interest rates in 2022, but analysts say that for the pound to rise higher in a sustained manner it will take an earlier hike, or more than one interest rate rises after 2022. Markets are hopeful that the economy will expand, and the labour market improve in order to see any substantial shift higher in the pound’s performance.

Short-term pound volatility

Federal Reserve Chair Jerome Powell's speech to the Jackson Hole economic conference on Friday will possibly offer few new hints about ending its quantitative easing programme. If it does show any clear indication that it intends to proceed with tapering the $120 billion in monthly purchases of Treasuries and mortgage-backed securities, then this will have a negative impact on global economic growth, but it will be supportive of the Dollar. If the Fed indicates that they are not yet ready to proceed to reduce its massive asset purchases, as the delta variant continues to spread rapidly igniting further fears of an economic slowdown, then the US dollar will fall. As Goldman Sachs economists have said earlier this week, Powell will be cautious not to lock in a specific date for starting the taper and he would keep the possibility for starting in November open.

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Sterling’s major weakness in the near future is a potential weakening in risk sentiment which will also weigh on global stock markets, hitting risk-correlated currencies. According to analysts, global risk sentiment will remain one of the key external drivers of the UK currency. At the same time, if global developments improve and equities stabilise, the pound will still need a boost from domestic factors such as stronger domestic data to recover some of its most recent losses. For the pound to continue to strengthen, the market will need to become convinced that the medium-term growth outlook for the UK economy is improving markedly. This would require some real productivity gains to be realised over the coming months and years.

While UK fundamentals have proven to be supportive, the global picture is very important for Sterling, especially when stock markets suffer, risk sentiment is low, and investors are usually spooked.

Risk appetite in global financial markets

Analysts have noticed a pattern emerging where the pound falls against the euro in times of risk off conditions. The pound commonly benefits from strong global growth, which has also been the case for the euro. When there is limited financial risk, investors tend to take more risks, therefore creating a “risk-on” situation. However, when there is uncertainty and high volatility, what is also called a “risk-off” environment, traders want to avoid risk and they sell their higher-yielding assets and move their funds to safe-haven currencies.

The euro as a risk-off currency

While the euro like the pound has been the beneficiary of positive market sentiment, more recently, this has changed, and it seems that the single currency benefits against the pound when global investor sentiment weakens. What this means, is that the euro has become a risk off currency.

  • Risk off currency

A risk off currency gains when stock markets decline as investors want to avoid risk and sell their risky assets.

  • Cyclical currency

The euro used to be seen as a cyclical currency but is much less now. Cyclical currencies such as the pound and AUD tend to appreciate when global economic growth is expanding, unlike the US dollar, the yen and Franc which are seen as safe havens.

The euro has benefited when stock markets are selling off and it has given the impression that is a safe-haven asset. According to research from HSBC, due to the low interest rate environment in the Eurozone, billions of cheap euros are borrowed, sold and repatriated into euros, creating demand on the currency and “establishing an impression that it is now a 'safe haven' asset during times of market stress.” Head of FX Research at HSBC Paul Mackel explained that this shift in the euro “comes down to the low growth, low rates environment that has become seemingly endemic in the region,” and is “a consequence of the ECB’s quantitative easing programme and shift to negative rates.” Mackel added that "Signs that rates may be lower for even longer could encourage these outflows to continue, or even exacerbate them.”

"For many years, the EUR was seen as a cyclical play, which benefited from strong global growth. However, the last decade or so has seen overseas asset accumulation outstrip inflows from foreign investors. This could start to change the way in which the EUR behaves,” Mackel said.  

Pound-Euro outlook

If you are a business exchanging pounds to euros or vice versa, it is beneficial to understand this dynamic and how risk sentiment and appetite affect the currency pair. For the pound then to appreciate against the euro, there will need to be improvement in global market conditions. If, on the contrary, global growth and markets are at risk, the euro could appreciate. The rapid spread of another Covid variant or any quick move by the Federal Reserve to withdraw its financial support are seen as major risks to the global economy and the pound in particular.

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The British currency rose against the US dollar and the euro, after the return of investor confidence.  With the recovery of major stock markets, investor risk appetite returned helping boost currencies such as the pound which are closely influenced by global market sentiment. The pound is considered a risk currency and is vulnerable to risk-off sentiment at times of risk-on.

Major concerns such as the Delta variant and the Fed’s removal of its stimulus programme will be the main drivers for global currencies such as Sterling. While there is still significant uncertainty about how the delta variant will affect markets, most developed economies are expected to grow steadily. Nonetheless, Sterling will remain sensitive to global developments than domestic economic data, as the economic calendar is thin with releases of little impact.

Risk on and Risk off sentiment

The widespread risk on and risk off sentiment, also known as RORO is the major driver of currencies in the market at the moment. Two of the key concerns of global investors are the withdrawal of the Federal Reserve’s stimulus and the rapid spread of the Delta variant in Asia.

But what is exactly risk sentiment? Simply, risk-on risk-off refers to shifts in investment activity as a result of global economic events. The foreign exchange market is basically affected by changes in the ways investors behave and where they choose to invest. The theory states that investors engage in higher risk trades when the risk is considered low and avoid high-risk investments when the risk is perceived to be high. So, investor appetite changes depending on global sentiment and whether risk is high or low. For example, the 2008 financial crisis was considered a risk-off year, as investors avoided risk by selling their risky assets and turning towards low or no risk positions such as U.S. Treasury bonds.

The risk-on risk-off sentiment is also affected by different asset classes, as some carry higher risks. Stocks are riskier than bonds and so when stocks are preferred more than bonds then the market is considered a risk-on environment. A risk-on environment is one where investors invest into riskier assets.

A risk-on environment is usually one where a combination of positive economic factors, data and events co-exists, showing that the market is healthy and strong, and risk is limited. Strong economic data such as corporate earnings, an optimistic outlook, and supportive central bank policies reflect a market where investors have more room to take on more risk.

Federal Reserve and monetary stimulus

In the coming week, the fundamental concern for markets will be the Federal Reserve's decision to withdraw monetary stimulus. On Thursday, Federal Reserve Chair Jerome Powell will give a speech at the Jackson Hole central banking symposium and investors expect him to announce the Fed is ready to start reducing stimulus, possibly as soon as this September. While this is good news for the  US dollar, stock markets which have been supported by the Fed’s funding will find the news disappointing. This will also affect the British pound which could fall following such an announcement. For some analysts, Powell might avoid bringing up monetary policy at the symposium, but others believe that the dollar will weaken if the Fed postpones the planned withdrawal of its funding.

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As a business transferring funds abroad, you might have heard of currency hedging, or you might have even used it without realising it. If your business makes regular transfers overseas, hedging your risk is paramount. No matter what currency pair you need to trade in, exchange rates will potentially impact your bottom line. This is why, using hedging as a strategy to reduce risk is important, even when you might not benefit from it. The way to see hedging is as an insurance measure: if something goes really bad, then you will definitely protect your funds and your business.

Currency hedging

Put simply, hedging refers to currency strategies and ways to protect your funds from future currency movements. It involves entering a financial contract to limit the impact of foreign exchange risk on your international money transfers. Currency hedging is used by financial investors and businesses to reduce currency risks when conducting business internationally.

If you have an international business and want to safeguard your funds, then currency hedging is essential. In currency hedging, you can choose the type of contract that suits your needs and requirements so that you protect yourself from losing out if there are unexpected changes in currencies that will affect you. For example, businesses commonly use a Forward Contract, which locks in an exchange rate for a predetermined amount that can be used in the future, usually up to 12 months. Businesses very often have specific currency transactions they want to perform at a specified time and set intervals. By purchasing and booking a type of contract that will achieve their set goals and protect from unnecessary risks, they manage to reduce to a great extent their exposure to currency movements that might hurt their funds.  

While hedging can be complicated as there are various mechanisms to choose from when considering a hedging strategy, usually it is wise to understand and analyse potential foreign exposure and proceed to evaluate the relevant goals and actions needed to mitigate against that risk.

Why your business needs it?

Hedging is best suited to a business that deals with regular international payments and buys goods or services on an ongoing basis. If your business does not have such requirements and instead you want to send funds internationally whenever it is needed, then it will be more beneficial to have the freedom to take advantage of currency volatility and send your funds whenever the opportunity arises. If you commit yourself to a forward contract, then you might be missing beneficial market movements. So, currency hedging is ideal for businesses that depend on regular currency transfers and thus need to protect their liquidity.

If you are considering hedging, it is best to make sure that all goods or services’ orders are final and are going to be delivered, so you can confidently proceed to hedge based on those numbers. Unless you are sure, it is best to avoid committing to a contract based on estimates and uncertainty as this could leave you with a loss if your contract fails to go ahead. At the same time, you will also need to be aware, that even if you have taken the necessary measures and chosen to use a Forward Contract, it is possible that market volatility does not go against you, but since you have committed to the contract you need to remain faithful to it and complete it. For this reason, you have the choice to take advantage of both future and spot contracts and create a combination of hedging where you can still reduce the risk of any unexpected movements.

Currency hedging is also important when your business deals with countries where political or other events might amplify currency volatility. If you are trading with a currency that could be subject to extreme swings, then you need to make sure you are protected.

Managing currency risk is a specialised area. Universal Partners FX can help you develop the right hedging strategy and stay protected ahead of volatility.

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The weakened global investor sentiment has kept the British currency under pressure against both the US dollar and euro. Analysts believe, however, that this will only be temporary as has already been seen throughout the last year. Fears of a global economic slowdown due to the pandemic and the spread of the Delta variant in Asia, as well as expectations the Federal Reserve will withdraw stimulus have hurt global sentiment.

The pound is mainly impacted by Bank of England policies and domestic economic developments but also by global investor sentiment. As it stands, there is a risk-off/risk-on binary which is affecting the foreign exchange market. Pro-cyclical currencies such as the AUD, CAD, and NZD tend to appreciate during good times, as opposed to countercyclical ones which appreciate in bad times. In a risk-off world where traders are not optimistic, and want to avoid risks, such currencies as the AUD and NZD become more vulnerable. In the current situation, the spread of the pandemic and the rapid rise of the Delta variant in Asia has hurt these pro-cyclical and commodity currencies as their main trade partner is Asia.  The pound is also sensitive to global risk sentiment. The trajectory of the pound will then depend on investor sentiment.

Market sentiment: Factors to consider

The main concerns for markets are as we mentioned the Delta variant’s spread in Asia and worries about the Federal Reserve withdrawing financial support. These concerns have prompted traders to wind back their bets on a strong economic recovery. With the general sentiment being cautious and nervous, the pound is under pressure, while the US dollar has strengthened.

  • Federal Reserve

The Fed is expected to announce a reduction to its quantitative easing programme some time between the Jackson Hole Symposium and September. This will open the way to a rate hike towards the end of 2022 and beginning of 2023. The news has now pushed the US dollar higher, whereas the pound is as low as it was the end of July.

  • Fears of slowing economic growth

The expected taper to the Fed’s programme combined with fears of slowing economic growth as Asian economies grapple with rising Covid cases has clouded market sentiment. The two factors are interrelated, as economies are currently dependent on and expectant of support from their central banks. With the Fed withdrawing support and the Delta variant spreading across Asia and hurting economic growth, the question is whether this is just a temporary concern. For analysts this won’t change markets massively and that the Fed’s anticipated tapering has already been priced in. The Covid threat has been there and continues to affect markets, and any weakness is seen by traders as an opportunity to buy cheaper assets.

So, this is seen as history repeating itself, with the pound’s weakness being just temporary.

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The pound might experience some volatility today as the Bank of England delivers its August policy decision and Monetary Policy Report. Analysts expect the pound to rise against both the US dollar and euro. At the same time, with many not expecting any major shifts in the bank’s policy, analysts will focus more on Governor Andrew Bailey’s tone and comments for guidance. If the bank strikes a hawkish tone, then the pound might rise, but if it is dovish, then the pound could fall. In general, the market expects interest rates to rise by the end of August 2022, which could help boost the pound, but if a rate increase is pushed back into 2023 then the pound might react by falling.

Scenario 1: Pound could rise

If there are signs that the Bank of England is moving toward ending its quantitative easing programme by the end of 2021 and raising interest rates in 2022, then the pound will find support.  

A currency strategist at UBS said: "We are likely to be served a more hawkish tone, but it will likely fall short of any policy announcement. Still, with nearly all restrictions now removed and COVID-19 cases falling back in the UK, we continue to believe sterling should outperform against both the dollar and the euro over the coming months.”

Market analysts also feel that if there are dissenting voices in the Monetary Policy Committee, then the pound could rise as the possibility of an earlier-than-expected reduction of the QE programme could happen in future meetings. Some monetary policy committee members have already hinted that they may support an early end to quantitative easing (QE), especially following the rise in UK inflation. That could help offer support to the pound. The Bank of England could also provide more clarity regarding the ways it will seek to slowly reduce its QE programme, which will also be met as a positive sign. If the bank offers a clear signal that it will assess the size of its QE in each meeting or even better intends to conclude it in the autumn, then this will be clearly bullish for Sterling.

Scenario 2: Pound could weaken

If there is any disappointing news from the Bank, then the pound could weaken. While market expectations have been boosted due to hawkish comments by Bank of England members for a reduction of the BoE’s asset purchase programme, these could be subverted, as the Bank might stress more risks ahead and weak market data. For this reason, the BoE might want to wait and see how the labour market performs and if wage growth is sustainable before they make any rush decisions. This is why the Bank might strike a more cautious tone, as they would like to see more data assessing the status of the economy, especially after the end of the government's furlough scheme in September. Some analysts expect a more hawkish tone in February 2022 when economic activity is expected to be back to normal.

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The pound fell against the euro and US dollar ahead of Thursday's Bank of England policy meeting. The fall is a result of investors’ belief that the pound will fall further. More generally, the third wave in Covid-19 infections and the slowdown in business activity has not helped boost market sentiment. If the bank strikes a cautious tone, market analysts believe that the pound might suffer.

Bank of England

Markets are expecting the Bank to keep interest rates and its quantitative programme the same, without making any major changes to its policy. But, it is also expected to readjust its economic forecasts and provide further guidance about the end of its quantitative easing programme while also offering a general outlook for interest rates. Thursday’s policy update coincides with the release of the quarterly Monetary Policy Report which will possibly shed some more light on when a 2022 interest rate rise will happen.

If the quantitative easing programme is reduced or there is a larger than expected increase to the BoE's inflation projections, the pound could get a boost. The latter will increase the possibility of a rate increase much earlier than expected. In general, if the bank provides more clarity on how it will begin cutting down its stimulus programme, then the pound will most likely rise.

Bank of America analysts are very hawkish and positive and expect the Bank of England to raise interest rates to 0.25% in May 2022. If the bank does signal a rate rise for 2022, then the pound could rise higher.

Outlook for pound

For economists and analysts, buying Sterling with the expectation that it will rise is something that makes sense, despite the dissenting voices of some of the bank’s members. While getting the economy back and running to pre-pandemic levels might take a while, the path towards normalisation seems clear. The pound’s path, however, might find possible obstacles if the US dollar rises.

Other analysts, believe that the fundamental backdrop remains unsure for Sterling and that any gains are short-lived, as they remain cautious.

Economists at HSBC do not expect any major shifts at the Bank of England’s meeting on Thursday, so the GBP/USD pair may experience some downside pressure. According to them, the cautious tone of the bank will hurt the pound. They said: “The GBP remains somewhat attuned to global risk appetite and so may see its fortunes partly determined by this factor, but local drivers seem to be getting more dominant and suggest further depreciation pressure over the near term. Given the rapid spread of the COVID-19 Delta variant, the removal of most remaining restrictions on 19 July has failed to provide the GBP with a boost. At the Bank of England’s (BoE) meeting on 5 August, a cautious tone (warning against the dangers of premature tightening) is likely to be prominent, as uncertainty remains high and most policymakers view the inflation upswing as temporary. The rates market prices in a 15bp hike in May 2022 for now, and so if the BoE repeats its cautious tone, this may pose some downside risks to the GBP.”

If you are a business transferring funds overseas, contacting a currency specialist could save you time and money. Get in touch with Universal Partners FX and their dedicated team to discuss the latest market movements ahead of your currency exchange. If you are transferring funds to pay your employees abroad, get in touch with Universal Partners FX to find out how much you can save in your international money transfers. Universal Partners FX can provide invaluable help on efficient risk management and tailored solutions to your business’ transfer needs.