GBP/USD recovered some of its earlier losses as investors tried to assess the latest data releases from the UK. The pound’s reaction to the UK data was muted. The ONS reported that the UK GDP grew by 1% in Q4, compared to the market expectation of 1.1%, and Industrial Production expanded by 0.4% on a yearly basis. The larger than estimated traded deficit did not impress markets and did not provide any momentum to the GBP/USD pair.

The pound’s recovery was the result of a weaker US dollar as retreating US Treasury bond yields stopped any gains for the greenback and helped the pound rise. Market participants now look forward to the US release of the Preliminary University of Michigan US Consumer Sentiment Index. The release, along with market sentiment and US bond yields will be the main drivers for the GBP/USD currency pair.  

UK GDP report

Despite the disruption caused by the Omicron variant in December, the UK economy continued to grow in the final quarter of 2021. The UK GDP report published by the UK's Office for National Statistics (ONS) revealed that the UK economy grew by 1% on a quarterly basis in the fourth quarter. This reading came in slightly lower than the market expectation of 1.1% but failed to trigger a market reaction.

The ONS said: “The largest contributors to this quarterly increase were from human health and social work activities driven by increased GP visits at the start of the quarter, and a large increase in coronavirus (COVID-19) testing and tracing activities and the extension of the vaccination programme.”

Darren Morgan, director of Economic Statistics at the ONS, said GDP fell back slightly in December but “grew robustly across the fourth quarter as a whole with the NHS (National Health Service), couriers and employment agencies all helping to support the economy.”

UK posts the fastest growth in the G7 in 2021

The UK economy grew 7.5% in 2021, the fastest since the 1940s, after it recovered from the pandemic. It is the fastest growth since the second world war, despite the disruption caused by Omicron in December. It is ahead of the US (5.7% growth), France (+7%), Germany (+2.7%), and Italy (+6.5%) as well as the EU (+5.2%), and possibly Canada and Japan who have not released their 2021 GDP data. But, the UK is recovering from a lower base, since its economy contracted 9.4% in 2020, much lower than other G7 members.

A resilient economy

Chancellor of the Exchequer, Rishi Sunak praised the government’s support for helping the economy say strong and grow. He said: “Thanks to our £400bn package of support and making the right calls at the right time, the economy has been remarkably resilient; with the UK seeing the fastest growth in the G7 last year and GDP remaining at pre-pandemic levels in December. I’m proud of the resolve the whole country has demonstrated, and proud of our incredible vaccine programme which has allowed the economy to stay open. We’re continuing to help the economy rebuild through our Plan for Jobs, boost for business investment and support for households with the cost of living.”

 

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Sterling fell slightly lower on Wednesday but stabilised following comments by the Bank of England Chief Economist Huw Pill. Pill hinted that the Central Bank will take time starting active QE sales and he cautioned against an “aggressive” approach to rate rises. He argued that a case can be made for a measured approach to policy decisions.

Huw Pill

Bank of England Chief Economist Huw Pill has disappointed market expectations that the Central Bank will quickly begin active bond sales from its quantitative-easing program once interest rates hit 1%.

Speaking to the Society of Professional Economists on Wednesday, Huw Pill explained that letting the base rate remain at 0.5 percent would leave inflation above the Bank's target of two percent. He explained: "Following the market-implied path to 1.2 percent by the end of this year would have left inflation somewhat below target. I leave it to you to draw any implications for where the MPC sees the path of Bank Rate headed."

He said that “financial markets have come to expect a lot of guidance from Central Banks on where rates are heading.” But as we move back to a more normal monetary policy situation, Pill recognised that it was natural for the Central Bank to withdraw from detailed guidance. He added: "I am not going to give any specific view of what the yield curve should look like. It does not make sense to pre-empt market pricing judgements."

BoE's Pill: “Steady handed approach to monetary policy”

Pill cautioned that the Bank "Must focus on more persistent developments in the data that have lasting implications for the outlook for price stability." He explained that this is what he “would label a ‘steady handed’ approach to monetary policy." It is "Better to adopt a more measured and data-dependent approach, which learns from how the economy responds to each step taken rather than pre-commits to a concept surrounded by uncertainty," he said.

Pill defended the Bank’s approach and said that since September, it “has consistent, measured and resolute set of actions intended to rebalance the stance of monetary policy and address the inflationary pressures." He also said that they have indeed “signalled that more is to come in the coming months if the path sketched out in our February forecast plays out." However, he said that the Bank has also warned that the outlook for the bank rate in the coming months is uncertain due to the risks to inflation.

Bank rate decision

The decision to vote for 25 bp hike rather than 50 bp decision “was finely balanced” for Pill, as he noted, and that he was sceptical “of efforts to return the Bank rate quickly to some pre-defined neutral level or terminal rate." As he clarified, "Such an approach risks increasing inflation and output volatility if the policy is miscalibrated."

He admitted that due to the current inflationary pressures he could definitely understand why his colleagues on the MPC voted for a 50bp hike last week. He also noted that he would not want to rule out changes in the bank rate of more than the usual 25bp. He said: "Restricting ourselves to a 25bp now – albeit with the prospect of more to come in the coming months – is an investment in containing market expectations of aggressive activism."

 

Inflation concerns

A key concern for the Bank is that inflation will become entrenched as firms increase prices to respond to rising costs and workers demand higher wages to deal with the cost-of-living squeeze. Bank of England Governor Andrew Bailey was criticised last week after suggesting that workers should not demand big wage rises. Pill warned that if these second-round effects of inflation weren't restricted "a further monetary policy response would be required."

Inflation has been rising steadily and the Bank avoided raising interest rates until December as it was concerned about the health of the jobs market following the end of the furlough scheme. The jobs market has remained tight than previously expected in November, but with a high number of vacancies and staff shortages.

Last week's rate hike marked the first time the base rate had been raised in two consecutive meetings since 2004. Markets are currently pricing in several interest rate hikes and are forecasting interest rates to rise to 1.25 percent by December.

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The pound is expected to remain supported by market expectations of further interest rate hikes, according to analysts. The prospect of a much stronger euro is although questionable, as it is believed that the euro rally following last week's European Central Bank comments has possibly run out of steam.

The pound rallied against the euro and reached its highest level in two years last Thursday after the Bank of England raised interest rates, but those gains were soon erased by the Governor Andrew Bailey’s cautious tone and warnings about slowing domestic growth.

Sterling to remain supported

However, analysts have stressed that the Bank’s determination to hike rates to control inflation and the fact that it has overdelivered in the last two meetings, should keep further rate expectations high and sterling supported. Barclays forecast that the Bank will hike 25bp back-to-back in both March and May. Barclays also expect the pound to strengthen against the US dollar but drop against the euro by mid-2022.

It has also been argued by analysts that there are some factors that offer support to Sterling and suggest the economic outlook is not that negative. Paul Robson, Head of G10 FX Strategy, EMEA, at NatWest Market has mentioned that the January UK PMIs indicate a decent pick-up in activity in the last week of January, while the government’s announcement of fiscal measures will help to balance the cost-of-living rise. He also added that the removal of travel restrictions could support sectors of the economy that have been hit by the pandemic.

Concerns about the pound outlook

Analysts remain cautious about the pound’s appreciation and note that its gains might be limited due to the adverse economic background against which the BoE is tightening its monetary policy.

Additionally, the Bank’s hiking cycle is now fully price in by markets and any unexpected changes and disappointment could result in pound weakness.

ECB and interest rate hikes

Analysts have also pointed out that the market might be already pricing in too many interest rate hikes from the ECB. When last week the ECB said all members of the governing council were concerned about Eurozone inflation, markets understood that it might change its policy and start tightening monetary policy like other central banks. The market now expects two hikes, but for rates to be hiked in 2022, then the tapering of quantitative easing will have to accelerate, especially since  ECB President Christine Lagarde is resolute that the normal sequence of QE and then rate hikes will be followed.

Barclays have said that they now expect a March announcement of a faster tapering of asset purchase and 25bp rate hikes in both March and September 2023. Markets now expect the ECB to hike and tighten monetary policy much earlier than expected and closer to the US Federal Reserve and Bank of England. This scenario will be supportive of the euro.

On Monday, ECB President Christine Lagarde emphasised that Eurozone inflation risks are on the rise, but price pressures could still recede. She said: “Demand conditions in the euro area do not show the same signs of overheating that can be observed in other major economies.” She added: “This increases the likelihood that the current price pressures will subside before becoming entrenched, enabling us to deliver on our 2% target over the medium term.” Markets now price 50 basis points of rate hikes for 2022, but economists are more careful, with most forecasting the first one at the end of the year or early 2023. Of course, markets will gain more clarity as we move closer to the ECB's March policy meeting.

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The pound dropped against the euro last week but could slowly recover if the euro does not rise any further. Sterling rose sharply after the Bank of England’s Thursday decision to lift the Bank Rate from 0.25% to 0.50%, but experienced losses when Governor Andrew Bailey and other members of the Bank’s Monetary Policy Committee warned of risks to economic growth and that meeting market expectations for the Bank Rate could eventually lead inflation to fall below the Bank’s target level of 2%.

The forecast for inflation anticipates inflation to remain elevated above the Bank’s target for more than two years and to fall below 2% in 2025. This means that the Bank might avoid raising rates in 2023, despite market expectations.

Thursday’s European Central Bank (ECB) policy decision

Sterling fell due to the Bank of England’s cautious tone and concerns about the effects of the recent increase in energy and international traded goods prices. But it was the hawkish shift of the European Central Bank last Thursday that also deflated the pound and boosted the euro. The foreign exchange market moved sharply and resulted in the euro rising higher. After ECB president Christine Lagarde said that Eurozone inflation risks have increased, financial markets expectations for a potential end of negative interest rates rose. The euro rally could extend, and this will be an ongoing risk for the pound.

Rising inflation and cost of living squeeze

Economists have warned on Monday that inflation will hit UK economic growth this year as consumers have to deal with the rising cost of living.  In its latest quarterly assessment of the economy the EY Item Club has cut its forecast for UK economic growth this year to 4.9%, as the squeeze on households’ spending power and the omicron variant slow economic recovery. The EY predicts inflation to hit 7% in the spring and real wages to fall. They also expect the Bank of England to hike the Bank Rate to 1% by the end of this year.

Hywel Ball, EY’s UK chair, says: “The forecast shows that the economy’s bounce back in 2021 was stronger-than-expected and Omicron’s economic impact is likely to be temporary and limited. While the economy and UK businesses may have a softer launch pad for growth this year, they will still benefit from a number of tailwinds in 2022 and 2023. But blowing in the opposite direction will be a squeeze on household spending power which is expected to be a bigger headwind for the economy than the Omicron variant. Inflation is set to reach its highest level in thirty years by the spring and will be well ahead of pay growth. Although the latest forecast says that the economic scarring from the pandemic is likely to be minimal, policymakers still face the challenge of how they help support households through the forthcoming squeeze on their finances and give companies the confidence needed to unlock business investment. The push towards Net Zero certainly creates an opportunity for investment growth.”

What to watch this week

The pound will be sensitive to any comments made by BoE Chief Economist Huw Pill on Wednesday’s online event with the Society of Professional Economists and Governor Andrew Bailey on Thursday’s online event hosted by TheCityUK. Friday’s UK GDP figures for December and the final quarter will also reflect the effects of the Omicron variant on economic activity into the end of the year. The GDP is expected to have fallen by -0.5% in December and to have grown by 1.1% for the final quarter.

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The pound rose against the euro and the dollar after the Bank of England voted to raise interest rates to 0.5%. The Monetary Policy Committee (MPC) voted by a majority of 5-4 to increase the Bank Rate by 0.25%.

While Governor Andrew Bailey, deputy governors Ben Broadbent and Jon Cunliffe, chief economists Huw Pill and external member Silvana Tenreyro voted to raise the rate from 0.25% to 0.5%, deputy governor Dave Ramsden, and Catherine Mann, Jonathan Haskel and Michael Saunders all voted for a 0.75% increase. These four members argued that monetary policy should tighten faster, to “reduce the risk that recent trends in pay growth and inflation expectations became more firmly embedded.” This points that further hikes will be coming soon.

Inflation to rise above the Bank’s 2% target

The Bank of England has increased its inflation forecast and expects inflation to increase 7.25% in April. This is over three times higher than its 2% target and shows how difficult the cost of living squeeze will be.

The Bank said that energy bills will rise in April while goods prices will also continue to increase. The rise in inflation reflects this rise in global energy and tradable goods prices. Inflation will rise more in the coming months before peaking at around 7.25 in April.

Bank will start unwinding its £895bn stimulus package

The Committee voted collectively for the Bank of England to begin to reduce its £875bn stock of UK government bonds, by not buying new gilts when they mature. They also voted to reduce its £20bn stock of corporate bonds on its balance sheet, by not reinvesting maturing assets and by selling bonds.

Subdued growth

The Bank also warned that unemployment will rise, and growth will slow down, as the Omicron variant impacted on economic activity in December and January. While a recovery is expected in February and March, in the longer term, UK economic growth is “expected to slow to subdued rates.” Rising inflation will hit household incomes and spending and push up unemployment. The BoE explained: “The main reason for that is the adverse impact of higher global energy and tradable goods prices on UK real aggregate income and spending. As a result, the unemployment rate is expected to rise to 5% and excess supply builds to around 1% by the end of the forecast period.”

The Bank anticipates unemployment to fall further to 5% by the start of 2023.

Earning Squeeze

The Bank of England is concerned that UK families will suffer in terms of living standards as disposable incomes will shrink by 2% this year, and by another 0.5% in 2023. This is the biggest reduction since 1990.

Sky News’s Ed Conway said: “The fall - largely a consequence of higher energy bills but also the rising tax burden and comparatively weak earnings - is considerably bigger than 1.3% fall in 2011, up until now the biggest squeeze since the statistical series begin.”

As the governor of the Bank of England said, the “hard message” is that “we are facing a squeeze on real incomes.” So, this is why the Bank decided to raise interest rates, otherwise the effects will be much more damaging.

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The pound has risen to multi-year highs following buying interest ahead of the Bank of England’s rate hike decision on Thursday (3rd February). Economists are warning that the pound could later in the year fall under pressure following economic disappointment.

Sterling recorded gains against both the euro and the US dollar as investors anticipate a second Bank of England interest rate that would possibly take the Bank Rate to 0.50%.

Bank of England

Market expectations for higher interest rates show that investors believe that inflation will remain high above the Bank’s target of 2% for a longer period of time. This will encourage the Bank to proceed to further interest rate hikes as the economy is recovering and has shown signs of resilience despite the spread of the Omicron variant. The UK economy has strongly bounced back compared to other major economies.

UK economy

The UK economy shrank during the months of December and January but is expected to rebound in February, according to economists. With restrictions lifted and less employees self-isolating, businesses will slowly return to normal and consumer confidence will rise.

If such expectations are justified and the economy is proven to be on the right track, then the Bank could raise interest rates in February and signal even further hikes in the coming months.

Thursday’s Bank of England meeting will be closely watched by investors for any indications that the Bank will proceed to a faster monetary policy normalisation which could provide support to the pound.

MUFG's Head of Research Derek Halpenny said that the Bank of England will prefer a “more front-loaded” action “with an additional 25bp hike in May helping support GBP versus the euro but later in the year risks of slower growth could push the BoE to the sidelines and result in the pound reversing versus the euro.” Other economists have also warned of slower economic growth later in the year as consumer spending is limited by increased inflation and tax rises, which could push the Bank to abstain from raising interest rates.

Comments from the Bank’s Monetary Policy Committee member Catherine Mann also suggest that it is better to act early rather than to proceed to a high “terminal” Bank Rate later, as to provide support to businesses and act on inflation.

Inflationary pressures

Workers and consumers will experience a loss of earning power as inflation rises and exceeds 7.0% in the first half of the year. Utility bills are expected to rise in April too, putting more pressure on households. The introduction in April of a hike to employee and employer National Insurance and the fact that income tax bands will be frozen, will result in households paying higher taxes.

Economists have also noted that both the euro and the US dollar will face challenges ahead, with the dollar’s rally to end this year. The US dollar dominance has been priced in as the Fed now seems ready to deliver up to 7 rate hikes this year, which means the greenback might start seeing some underperformance against advanced economies that become more aggressive in tightening their policies.

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Sterling strengthened against the US dollar on Monday and for a short time hit 23-month highs against the euro at the beginning of the week. The British currency is expected to rise further if the Bank of England proceeds to raise interest rates for the second time in a few months.

Markets anticipate that the Bank of England will most likely raise interest rates on Thursday in an attempt to fight rising inflation levels which could reach 7.0% and remain above the Bank’s target for months.

Markets’ great expectations

These expectations have helped boost the pound, but to continue offering support the Bank will need to act accordingly and not disappoint the markets. More than 100 basis points of rate hikes are now expected to be delivered in 2022, but such great expectations might be too optimistic, analysts have noted. These expectations have been priced in by markets, so any disappointment, or any indication that there will be less rate hikes could push the pound lower, especially after its recent highs against the euro.

It has been noted that if the Bank proceeds with a 25-basis point rate hike on Thursday while remaining hawkish and positive, indicating that there will be more hikes to come, this will help the pound rise against the euro.  

Craig Inches, portfolio manager at Royal London Asset Management, has said that markets might not expect a more hawkish BoE: “If they move interest rates to 0.5%, the market will expect them to announce they won’t be reinvesting the proceeds of the March 2022 gilts .... that will be the first sign we see of how markets react to balance sheet reduction.” Money markets are pricing rates at 1.25% by the end of the year.

Inflation

Analysts have noted that the Bank itself will not want to hurt markets and lower expectations as a strong pound will help ease inflationary pressures. They note that the Bank is actually welcoming the strength in the pound as it will help it fight the rising energy prices.

A strong pound means that the cost of imports will be cheaper, and because the UK is a net importer, this will act as a deflationary source.

HSBC noted that the BoE would signal even higher inflation ahead, or that it will cut its balance sheet: “If the terminal rate were to be adjusted much higher, due to either of the above forces, it would provide more ammunition for rate hikes and would create a less negative backdrop for sterling.”

ING expects the Bank to hike rates 25 basis points and raise their inflation forecasts while clarifying that medium-term growth has not been affected by Omicron. If the Bank decides to go against market expectations, then it will possibly justify such a move by saying that more time is needed to gather more data regarding Omicron’s impact on the economy.

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