The pound fell 2% against the US dollar yesterday after the Bank of England raised interest rates up to 1% but painted a gloomy economic outlook warning about a possible recession at the end of the year.  The pound sustained significant losses against the euro and the US dollar but is trying to recover ahead of the weekend.

The Bank of England’s economic forecasts published in its Monetary Policy Report shocked markets with their cautious and pessimistic tone and analysts said that the pound will remain weak for some time.  Derek Halpenny, Head of Research for Global Markets EMEA at MUFG said that the outlook for the pound will be as “grim” as the GDP forecasts delivered by the BoE yesterday.

The BoE might not be the only bank that strikes a cautious tone and warns about the gloomy economic outlook, as other developed market economies face similar inflationary and growth challenges, and their central banks will also have to slow down their rate hike expectations in the coming weeks. If this does happen, the pound could begin to strengthen.

No more rate hikes?

The BoE has definitely surprised markets with some members of the Monetary Policy Committee supporting a 25bp hike but not referring to further rate hikes, suggesting that the MPC is near the end of its hiking cycle.

The BoE's growth forecasts with the 2023 GDP growth forecast being slashed by 150bp to -0.25% was perhaps the most surprising, as the MPC expects the economy to contract in 2023.

As we previously noted, the pound’s shock is linked to a difference of opinion and expectations between the Bank of England and markets. The market was pricing 8-9 more rate hikes from the BoE in the next year or so and more than 25bp hikes in the next two meetings.

Markets expect too many rate hikes, analysts warn

While the Bank said more rate hikes are possible, these won’t be as many as the market is expecting and Sterling will continue to be under pressure.

Some analysts have said that the MPC may hike one more time in the current cycle by 25bp, while others noted that it could keep rates unchanged to avoid a recession, with the risk of inflation reaching extremely high levels.

Bank of America expects three more 25bp hikes in June, August and November, while Investec’s rate expectations have been lowered to 12bps to 2-2.25%. NatWest Markets believes there will be a 25bp Bank rate hike to 1.25%, in August, followed by a pause as the MPC assesses the risks from higher energy prices and the cost-of-living crisis.  

The pound will remain under pressure at least in the near-term as higher inflation risks and a waning rate hike cycle keep market sentiment weak. However, once other central banks begin expressing similar concerns as the BoE, then the pound is expected to start recovering, perhaps in a few months.

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The Bank of England is expected to raise interest rates to the highest level since the 2008 financial crisis, despite concerns about an economic slowdown and the cost-of-living crisis.  

The Old Lady of Threadneedle Street will likely raise interest rates by at least 25 basis points (bps) as already noted in the last meeting.

Base rate to increase to 1%

Markets widely expect the Bank to increase its base rate to 1% on Thursday, raising borrowing costs to the level set in February 2009. Households are under pressure from soaring living costs due to higher petrol prices and rising gas and electricity costs exacerbated by the war in Ukraine. Consumer prices could even reach 10% later this year, which is five times the Bank’s inflation target of 2%.

High inflation

High inflation is a global concern with central banks around the world raising rates to tackle inflationary pressures. On Wednesday the US Federal Reserve raised its benchmark interest rate by 0.5% to a target rate range of between 0.75% and 1%.

Bank of England’s 4^th rate rise in a row

Analysts expect the BoE’s Monetary Policy Committee (MPC) to vote for a fourth consecutive rate rise since December when it raised borrowing costs for the first time following the Covid pandemic. By increasing the rates to 1%, the Bank could begin selling some of its £875bn portfolio of government bonds which it created via its quantitative easing stimulus programme since the 2008 financial crisis.

The Bank is not expected to take immediate action but announce preparations for future asset sales, due to high volatility in the markets.

Analysts expect some of the members of the MPC to push for a 0.5% rate rise to show their determination to stop inflationary pressures from becoming entrenched, but a quarter-point rise remains the most likely outcome.

Recession concerns

There are concerns that persistently high inflation could lead to a recession if the increasing cost of living, higher taxes and borrowing costs damage UK consumer spending.

Recently, weak economic data disappointed markets and raised fears after the decline in March of retail sales and lower consumer confidence in April.

Kallum Pickering, a senior economist at Berenberg, warned that weak consumer confidence and evidence of diminished household demand is risky when raising interest rates. As he stated, “If we are unlucky, the UK is already in the early stage of a recession.”

How will the pound react?

The MPC voted 8-1 in favour of a 25 bps rise in March, with one person voting against. The pound could fall today, if there is any sign of widening disagreement among the MPC members to keep the interest rate unchanged, as it would mean that the rate hike cycle is close to a pause. 

If the BoE delivers a hawkish outcome, then this will be a positive development that will push the pound higher and offer support.  However, a cautious policy tightening outlook will hurt the pound.

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The pound is expected to stabilise ahead of the Bank of England (BoE) meeting on Thursday and fall after the announcement, especially against the US dollar, analysts have said.

Economists at ING noted that the BoE might disappoint market expectations on Thursday and said that the next few days will see investors being cautious and waiting to see what the Bank of England will decide. They said: “We think that would prompt a bit more dovish repricing across the GBP curve and the pound could moderately weaken after the rate announcement. Such weakness should prove more pronounced against the dollar, which could find some more support from the FOMC meeting.”

As others have warned, the pound will need to take a considerable “'hawkish' surprise from the Bank of England for it to avoid succumbing to the implications of any gloomier set of BoE economic forecasts this Thursday.”

While, for example, the pound has risen against the euro, this was mostly the result of a weaker euro as markets were concerned about the gas supply and economic risks from China’s lockdowns. But the pound remains at risk from the BoE’s updated economic outlook and inflation forecasts which could disappoint market expectations.

BoE interest rate expectations

The market’s rate expectations are too optimistic, and this could push the Monetary Policy Committee (MPC) to revise down its main projection for GDP growth, Samuel Tombs, chief UK economist at Pantheon Macroeconomics said. He indicated that is “extremely unlikely” that the MPC’s forecasts or comments will confirm the markets’ interest rate expectations. While the BoE is expected to raise the Bank Rate to 1% on Thursday, it might not continue its hiking cycle as it has warned that the cost-of-living crisis will reduce inflation over the coming years, and that interest rates may not need to rise as far as markets expect later in 2022.

The Governor Andrew Bailey has already said last month that the Bank will have to carefully decide how much more it should raise interest rates to curb inflation as it will need to consider the effects of the real income shock and a potential recession. The recent weak data such as March’s retail sales has shown that the squeeze on incomes has hit consumer spending. This is why the squeeze on incomes can be seen as a substitute for some interest rate rises, which could push the pound lower.

What to watch this Thursday at the BoE meeting?

The pound’s performance will depend on the BoE's decision about interest rates this week, the potential consequences of its updated economic forecasts and the language used in the statement and the accompanying quarterly Monetary Policy Report.

Economists have also highlighted that slowing down its hiking cycle does not necessarily mean is something bad for the pound and that many other central banks face similar concerns. However, the Bank’s task of tackling inflation while supporting growth might have negative effects.

A lot of economists have lowered their pound forecasts, as they expect the BoE to push back against market expectations for this year, which inevitably will also push the pound lower.

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The British pound was weighed down by weak domestic data, which showed that the UK economy is under stress from the rising cost of living. This has forced investors to cut back their expectations on future interest rate hikes by the Bank of England. With limited economic releases from the UK, the pound could drop further against the US dollar, analysts have warned.

The US dollar has strengthened as a safe-haven currency following concerns about supply-chain issues, a coronavirus-related lockdown in Beijing and the ongoing war in Ukraine. The prospect of aggressive Fed rate hike bets and the risk-off mood have pushed the US dollar to over a two-year high. On the other hand, diminishing expectations for further tightening by the BoE have pushed the pound lower.

Bank of England (BoE) to disappoint market expectations

Economists at Scotiabank have reported that the Bank of England may disappoint markets. They noted that if yield differentials go even lower, then the pound to US dollar exchange rate could fall lower. As they said, “The spread of 2-yr Gilts vs USTs has oscillated around -1% for the past four weeks or so but looks set to mark a new pandemic low in the coming weeks that would drive additional GBP weakness.” They added: “Another leg lower in yield differentials amid a cautious BoE vs a hawkish Fed (as well as some near-term political anxiety ahead of the May 5 local elections) could fuel GBP losses.”

Economists at ING also expect the pound to remain fragile. They said that one of the central themes of this year will be whether Central Banks will proceed to further tighten their monetary policy amid a global economic slowdown. It remains to be seen whether the Bank of England will tighten its policy. They believe is too early to write off Sterling especially against the euro.

Recession risks in the UK

Economists at Deutsche Bank have warned that recession risks in the UK are growing following the cost-of-living crisis. Sanjay Raja, Senior Economist at Deutsche Bank, said that "recession warnings are burning brighter," with inflation (CPI) expected to reach 9% year-on-year in April and October this year, which is "drastically hitting spending power.”

With tax rises biting into household budgets, consumer confidence has fallen considerably, while real wages are expected to shrink by 4% in 2022.

Raja warned that "The risk of a household recession may be even greater (household consumption shrinking), given the confluence of factors plaguing consumer spending.”

Such fears have contributed to markets lowering their expectations for future Bank of England interest rate rises. This in turn has pushed the pound exchange rates lower.

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The pound has plummeted and has hit its lowest level against the US dollar since September 2020. The release of disappointing economic data, including weak retail sales in March and the cost-of-living crisis which has affected consumer spending are some of the reasons behind the sharp drop. Additionally, markets have already priced in interest rate hikes by the Fed which is offering support to the US dollar.

CBI’s industrial trends survey of UK factories

On Monday, the Confederation of British Industry’s (CBI) first quarterly industrial trends report since the war in Ukraine started, highlighted the pressures on UK factories from rising costs. UK manufacturers raised prices in order to cover surging raw material and energy costs, and a further acceleration is expected, according to the CBI. Average costs grew at the fastest rate since July 1975 and firms increased domestic prices at the fastest pace since October 1979, which will feed through to consumers.

UK manufacturing confidence was hit after the war in Ukraine and rising inflation. Both business sentiment and export optimism fell in April, as both commodity prices and uncertainty increased.

Companies reported that productivity and new orders slowed over the last quarter, and new orders are expected to continue to drop in the next quarter.

Anna Leach, CBI deputy chief economist, said that manufacturing orders and output have continued to grow, but the war in Ukraine has made things more difficult, especially following the pandemic, as costs have risen and concerns about the availability of raw materials have grown. She noted that is not surprising that sentiment has weakened in the last three months with manufacturers cutting back their investment plans.

UK economy slowing down

UK retail sales disappointed markets while UK consumer confidence fell to lows last seen during the time of the financial crisis in 2008. The potential slowing of economic activity weakened the pound and markets are beginning to realise that they have aggressively priced in too many rate hikes for 2022. Some analysts believe that investors should remain cautious about the pound as the Bank of England will be unable to keep pace with the aggressive tightening cycle priced in by the currency market. 

S&P Global's PMI data for April also showed a further slowing in growth rates as inflation surged.

Derek Halpenny, Head of Research, Global Markets, at MUF said: "Downside risks for the pound are building with a host of specific negative developments providing reason for GBP sentiment to worsen over the coming days and weeks.”

Economists at MUFG Bank, also noted that the GBP remains vulnerable due to the economic slowdown and unfavourable financial market conditions. They noted that the policy divergence between the BoE and Fed will be sharper in the coming months. As more economic data demonstrates that the UK economy is experiencing a slowdown, they expect the BoE to become more cautious about further rate hikes this year. On the other hand, the Fed is more determined to proceed to further rate hikes this year, as the US economy is less vulnerable.

They warned that the pound will remain more sensitive than the US dollar due to concerns about gloomy global financial conditions following aggressive policy tightening.

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The pound fell sharply against the euro and the US dollar following a risk-averse market environment and disappointing data releases from the UK. On the other hand, the risk-off mood increased demand for the safe-haven dollar, while the euro surged to a near two-week high as markets have priced in an early ECB rate hike.

The pound came under pressure following cautious comments from Bank of England (BOE) officials and disappointing data releases from the UK. The Office for National Statistics reported on Friday that retail sales fell by 1.4% in March.

On Thursday, BoE Governor Andrew Bailey noted that UK inflation was more like that of the Eurozone than the US: "We must not be complacent about inflation expectations” as we are walking "a very tight line between tackling inflation, and the output effects of real-income shock."

Gloomy UK data releases

The risks for Sterling have increased following lower than expected economic releases. UK consumer confidence fell to very low levels last seen during the financial crisis of 2008, as consumers are now less confident about the economy.

Retail sales for April also disappointed with a reading -1.4% month-on-month in March. S&P Global's PMI data for April showed a further slowing in growth rates as inflation has surged.

Investors are cautious as they believe the Bank of England will disappoint markets who have priced in a more aggressive tightening cycle. With Friday’s release of gloomy consumer and PMI data, as well as political uncertainty at home and abroad, analysts have become more sceptical.

PMI data

PMI data showed that there was further slowdown in UK economic growth with the S&P Global/CIPS Services PMI Flash for April reading at 58.3, much lower than the 62.6 in March. Manufacturing PMIs came higher at 55.3, but services account for a bigger share of the economy. The overall Composite PMI came below the 59 forecast, at 57.6.

Demand was hurt from the cost-of-living crisis and economic uncertainty due to the war in Ukraine. Consumer confidence is very important as the UK is essentially a services economy and the way consumers and businesses spend their capital affects economic growth. The GfK said their UK consumer confidence measure is now "in freefall as Index crashes in April to -38." Joe Staton, Client Strategy Director at GfK said: “The cost crunch is really hitting the pockets of UK consumers and the headline confidence score has dropped to a near historic low." 

Retail sales

Retail sales for April dropped below expectations at -1.4% month-on-month in March, below the -0.3% markets expected. The March fall marks the second month that retail sales declined and demonstrated that the wage squeeze is affecting consumer spending.

Chief UK Economist at Pantheon Macroeconomics Samuel Tombs said that low consumer confidence means that households will withdraw their savings cautiously, but looking ahead, retail sales volumes are expected to fall further as households struggle with their finances and inflation continues to rise.

 How will the data affect the Bank of England’s decision?

The gloomy data will force the Bank of England to consider how fast it will hike interest rates as it shows an economy under pressure. The pound will also come under pressure as markets begin to cut back their rate hike expectations. With Inflation at a 30-year high of 7% and even rising higher in April, the Bank will be unable to curb inflation, as global oil prices and geopolitics are external factors outside its control. While the Bank needs to act by increasing interest rates, Friday’s data has undermined the pound with UK economic growth slowing down and hurting consumer purchasing power.

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The euro rose against the pound and the US dollar after hawkish comments by European Central Bank (ECB) policymakers who have indicated that the ECB could raise interest rates as soon as July. The euro-pound exchange rate rallied to a near two-week high as a result of the comments.

ECB policymaker Martins Kazaks said on Wednesday that an ECB rate hike could be delivered as soon as July. Policymaker Pierre Wunsch told Bloomberg early Thursday that policy rates could rise this year and ECB Vice President Luis de Guindos added that he was expecting the QE to end in July to open the way for an interest-rate increase the same month.

Later, on Thursday, markets will focus on ECB President Christine Lagarde's speech which could also contribute to the euro’s strength. On the other hand, the British pound has struggled to gain any momentum. Investors will remain cautious, however, as concerns about the potential economic fallout from the war in Ukraine could deter traders from investing aggressively and limit any gains for the euro in the near term.

ECB comments

Various comments by ECB policymakers seem to be an attempt to prepare markets for an interest rate hike which in turn has raised European bond yields and supported the euro exchange rates.

On Thursday, ECB Governing Council member Pierre Wunsch said that the ECB could raise policy rates above zero before the end of the year: "Without any really bad news coming from that front (Ukraine), hiking by the end of this year to zero or slightly positive territory for me would be a no brainer.”

Comments by de Guindos have been taken more seriously as he is closer to the centre of the Governing Council, as analysts pointed out. de Guindos said that it was "crystal clear" that the ECB forecasts to be released in June will show higher inflation and lower growth expectations. But, the possibility of a recession and stagflation in the Eurozone was not likely and for this reason it was reasonable to consider tightening in monetary policy. He noted: "I see no reason why we should not discontinue our Asset Purchase Program in July... for the first-rate hike we will have to see our projections, the different scenarios.” He added: "From today’s perspective, July is possible and September, or later, is also possible. We will look at the data and only then decide."

Euro to remain supported

The ECB said earlier in March that it intended to end its quantitative easing in the third quarter, but this has moved sooner now. The earlier timing and higher number of rate hikes that are now being priced in for this year will be supportive of the euro.

The single currency had a difficult time recently as the ECB postponed any plans for interest rate hikes compared to other central banks who had moved to normalise interest rates. Even more recently, in its April policy update, the ECB struck a reserved and cautious tone and offered no indication for an imminent interest rate rise. The latest hawkish comments by Kazaks and de Guindos demonstrate a radical shift and perhaps reveal a change of thought at the central bank. Any further comments or similar developments could boost the euro further.

Traders will closely watch later today the appearances from the ECB President Christine Lagarde, FOMC Chairman Powell and Bank of England Governor Andrew Bailey who will speak at the IMF Spring meetings. Unless Lagarde disappoints markets by dismissing the idea of hiking the policy rate in early-Q3, the euro will remain supported.

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The British pound rose against the US dollar on Wednesday, as investors turn their interest to potential policy signals from the Bank of England. The British currency was not troubled by Prime Minister Boris Jonson’s woes over the partygate scandal.

BoE governor Andrew Bailey and policymaker Catharine Mann’s comments along with European Central Bank chief Christine Lagarde’s remarks, at the IMF meetings on Thursday will be carefully watched with traders paying close attention to the policy divergence between the two central banks. Any indication on how the BoE will proceed in terms of further rate hikes, after data last week showed that UK consumer price inflation hit at a thirty-year high, will provide direction for the British currency.

Weak economic growth to limit further rate hikes

The BoE has recently disappointed markets by softening its language about rate hikes, and ING and MUFG have warned that it will likely further disappoint tightening expectations this year.

The International Monetary Fund (IMF) on Tuesday forecast slower economic growth and more persistent inflation for Britain next year, with global economic growth forecasts being slashed due to the war in Ukraine. IMF forecasts for UK GDP growth this year were cut to 3.7% while for 2023 the growth rate was almost halved to 1.2% from 2.3%.

According to ING, the bank pointed out to clients that currency markets are expecting only 30 bps of BoE tightening at its upcoming meeting due to concerns about the economic outlook. Market expectations for BoE tightening are too aggressive they noted. The bank’s economists expect a 50 bp whereas currency markets have priced in 150 bp of BoE rate hikes by year-end.

MUFG has also noted: “We are not convinced the BoE will be in a position to deliver what is priced into the market with growth likely to be very weak through the remainder of this year. We assume two further 25 bp rate hikes by the BoE and then a pause.”

Economists at Scotiabank expect the pound to US dollar exchange rate to fall significantly in the coming months as the Bank of England (BoE) will not meet rate hike expectations. As they said: “The rates, economic, and political picture point to losses firming under the figure in the near-term. The IMF noted yesterday in its outlook review that the UK will see the highest rate of inflation this year among G7 countries, and it revised its GDP growth projections for the UK by roughly 1ppt in each of 2022 and 2023 amid the cost-of-living crisis.” They added: “Weak growth and the cost-of-living crisis are likely to keep the BoE from hiking by as much as markets expect this year.”

Pound untroubled by PM Boris Johnson’s woes

The British pound was untroubled by Prime Minister Boris Johnson’s political woes. The British PM on Tuesday offered an apology for attending an illegal party during lockdown but clarified he didn't break any rules knowingly and didn’t mislead Parliament.

After his apology on Tuesday, British lawmakers will vote on Thursday on whether Johnson should be investigated for allegedly misleading Parliament. The motion is not expected to pass, given the Conservative party’s ruling majority in parliament. While the currency market is especially sensitive to political uncertainty, investors are not so much focusing on this. Even if Johnson leaves, analysts have noted that this will mean a change of personnel and not a change of policy. The market’s focus for now remains on hints on future rate hikes from the BoE.

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The pound rose against the US dollar in early trade, its highest in a week. It was also higher against the euro after the European Central Bank’s policy update did not offer any signs that it will proceed to raising interest rates any time soon. The ECB’s guidance was similar to the last one in May and disappointed markets who were expecting that policy makers would be more decisive about a 2022 rate hike to fight surging inflation.

While inflation is a global concern, the ECB avoided signalling an end to its bond purchase programme and stated they would continue to buy assets even after they start raising rates. The euro weakened following the news.

Inflation to remain high

In its statement, the ECB said that inflation has increased considerably and will remain high in the coming months because of the high energy prices. The bank did not show it was extremely concerned about wider price pressures in the economy. Earlier in March, the ECB said that it would end its asset purchase programme one quarter earlier than before which helped to push the euro higher. This is why market expectations were high today, and market participants were disappointed as the statement was not as aggressive as expected and no new policy changes were announced.

Many investors were looking for a more “hawkish” tone as inflation has risen especially following the war in Ukraine. The ECB did not touch upon the issue of interest rate rises, despite that the market was expecting 60 basis points of hikes for 2022.

ECB Press Conference

In a press conference, ECB President Christine Lagarde said that the central bank was focused on ending the asset purchase programme before raising rates, with the first hike coming some time after the ending of the asset purchase programme. Lagarde said: "We will maintain optionality, gradualism and flexibility in the conduct of our monetary policy.” Analysts expect the earliest rate to come in December, with the 60-basis point being an over optimistic forecast.  

At the conference, there was no mention of the new emergency tools that the ECB was exploring if bond yields of peripheral economies rose. The ECB was creating a so-called backstop to be used against debt-market pressures outside the control of individual governments.

The ECB’s cautious tone today drove the euro lower as the market was not expecting a softer attitude amidst surging inflation. European Central Bank chief Christine Lagarde’s comments were seen as a sign that the bank was not in a hurry to raise interest rates and offered no hard schedule and little specifics beyond the coming months. As she said, “We'll deal with interest rates when we get there."

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The pound rose after the release of better-than-expected inflation data on Wednesday that will strengthen the case for the Bank of England to raise interest rates in the future.  While this means that households in Britain will be burdened with the soaring cost of living as petrol and diesel prices have gone up, it is seen as positive news for markets and the pound as it will push the BoE to act.

Inflation data

According to the ONS, headline Consumer Price Index (CPI) inflation rose 1.1% month-on-month in March, more than the 0.7% that markets had forecast. The annual rate of increase came in at a 30-year high at 7.0%, exceeding the 6.7% expected and the 6.2% February figure.

The rise is the fastest in three decades. Core inflation rose by 0.9% in March, as price pressures increased, and this will have to be addressed by the Bank of England.

The chancellor, Rishi Sunak, attributed the rising costs to global supply chain and energy market pressures which could be made worse by the war in Ukraine. He said: “I know this is a worrying time for many families, which is why we are taking action to ease the burdens by providing support worth around £22bn in this financial year, including for the most vulnerable through our household support fund. We’re also helping as many people as possible into work – the best way for families to gain economic security in the longer term.”

Market reaction

Traders reacted by buying the pound as the data boosted expectations for more interest rate hikes, with 140 basis points of hikes expected to be delivered in 2022.

However, some analysts have warned that the pound’s gains might be short-lived as economic growth could slow down due to inflationary pressures which will hit households, consumer confidence and economic activity.

JP Morgan has warned that inflation might not be as positive as some may think and could  have a negative effect on the pound due to stagflation and an economic slowdown.

For households, if inflation moves above the 8% YoY in April and lasts for months after, then people will struggle in an economy that remains vulnerable.

For the coming week, if more data is strong and shows a tight labour market and consistent growth then this will mean that the BoE hiking cycle will continue, offering support to the pound.

Others believe that hiking interest rates will provide no help as inflation is being driven by an external energy shock. There is also the argument that inflation will do the BoE’s job and there is no need for hiking rates as it will destroy demand and recovery.

The outlook for interest rates has then become difficult to predict and this will make things for the British currency more complicated. In terms of inflation, it is expected to fall in 2023, below 2.0% in the second half of next year.

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