The pound fell on Wednesday despite the UK budget statement, which was in line with expectations. There was no indication that Chancellor of the Exchequer Rishi Sunak’s budget announcement contributed to the market movement. The fall is possibly linked to a drop in the yield of long-duration UK government bonds and shows that markets expect the government to reduce borrowing in the coming years.

2021 Budget

In general, news about today’s budget statement was positive about the economic outlook, regardless of the fact that there was no fiscal stimulus announced. Sunak, said he had asked the Bank of England to remain committed to controlling inflation and keeping it low and stable, as anything above 2.0% will not be favourable in the long term. Next Thursday, with the Bank of England meeting, pound volatility will be expected.  

Rishi Sunak said that his budget delivers a stronger economy, stronger growth, public finances and employment, so that it is possible to begin building the economy post-pandemic. As he noted: “Let there be no doubt: our plan is working.”

Growth

Sunak said overall spending will increase by £150 billion, the "largest increase in a century", as the economy is expected to grow and expand 6% in 2022. The chancellor said that forecasts from the Office for Budget Responsibility (OBR) show the economy will grow by 6.5% this year, 6% next year, 2.1% in 2023, 1.3% in 2024, and 1.6% in 2025. Unemployment is forecast to reach 5.2%, down from a forecast of 12% last year.

Inflation

The chancellor said inflationary pressures are currently impacting on the UK economy and the government will make sure to support households. The Office for Budget Responsibility (OBR) is expecting inflation to be around 4% next year.

Borrowing

Sunak said that will set new “fiscal rules” for public finances. During “normal times” the state should only borrow to invest in growth while balancing everyday spending. In the current financial year 2021-22, borrowing will be 7.9% of GDP, and will fall to 3.3% in 2022.

Employment and skills

The chancellor said the government will raise government spending on skills and training by £3.8bn. The government will create a UK-wide numeracy service called Multiply to help 500,000 adults. This is part of the government’s commitment to improving lifelong learning and productivity. While a lot of this has already been announced, the 43% increase in spending is considerable.

Business taxes

The bank surcharge will be cut from 8% to 3%. Business rates will be changed to help companies and a new 12-month relief will be provided to companies to invest in their premises. The incentives are worth £750m. Sunak said that 2022’s intended increase in the business rates multiplier will be terminated. There will also be a 50% business rate discount for companies in retail, hospitality and leisure. The cut is worth £1.7bn. The chancellor highlighted that “This is the biggest single year tax cut to business rates in over 30 years.”

Taxation and universal credit

Sunak also announced that the taper rate in universal credit will be cut from 63p to 55p. This will be worth more than £2bn. The work allowance will be increased by £500.  In regards to taxes, Sunak confirmed: “By the end of this parliament I want taxes to be going down, not up.”

The reforms to the universal credit system will enable only those in work to keep more of what they own and will encourage employment.

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The pound rose on Tuesday against both the euro and the US dollar, as stock markets increased, and expectations for an early November rate hike by the Bank of England remained strong. This is the highest level since the pandemic started in March 2020. If the Bank of England proceeds to an early rate hike, then markets will not be disappointed and the pound will rise further, as many analysts suggested. However, if it strikes a more cautious tone and reduces expectations for further rate hikes in 2022, then the pound could fall.

A hawkish statement by the Bank of England suggesting a faster cycle of hikes than is currently expected might boost the pound further, but this is not anticipated.

Interest rates

If the Bank of England raises interest rates as soon as the 4^th of November, then the UK central bank will be the first major central bank to raise rates ahead even of the European Central Bank (ECB). The pound rose against the dollar, but the gains were not substantial as the US Federal Reserve is on target to raise interest rates in 2022 with the November policy meeting likely to confirm this.

The lower number of Covid-19 cases has helped boost market sentiment and has given the Bank of England further evidence that the economy has the potential to grow as we come to the end of the year.

Current and potential obstacles

However, Britain's weak economic data, such as Friday's unexpected drop in retail sales has capped further gains. UK growth momentum is also weakening. There are also concerns about potential tax hikes that could be announced on Wednesday's budget statement, alongside tensions between the EU and the UK post-Brexit provisions relating to the trade between Britain, Northern Ireland, and the European Union member Ireland.

A possible headwind for the pound is the failure of the negotiations between the two sides over the Northern Ireland protocol, as Britain has threatened to take unilateral action if talks fail. #

Rishi Sunak’s budget announcement on Wednesday

Traders are now awaiting finance minister Rishi Sunak's budget statement on Wednesday. Markets might be already aware of his plans for higher corporation tax and national insurance contributions, but the devil is in the details. He is expected to end the public sector pay freeze for millions of workers and there has been speculation that the minimum wage for those aged 25-plus could increase from £8.91 an hour to £10 before the next election. For the NHS, there have also been announcements for a £5.9bn for NHS backlogs, diagnostic services and elective surgeries funding, while a £2.1bn is going to improve IT across the NHS. Another commitment has been for £5bn on health research and development over three years. A total of £850m has been promised to inject new life into the arts as a “post-pandemic funding boost.” £700m has been promised to be spent on the new post-Brexit borders and immigration system, and a new maritime patrol fleet. Among his other pledges, is a six-month extension to the COVID recovery loan scheme to June 2022.

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The pound fell following disappointing retail sales and a drop in the GfK Consumer Confidence survey, but reversed losses after the release of better-than-expected Preliminary PMI data for October.

PMI

The Markit/CIPS Manufacturing PMI for October came at 57.7, higher than the expected 55.8. The Services PMI also came at 58, higher than the 54.5 forecast and September’s reading of 55.4. The Composite PMI came in at 56.8, also above the forecast of 54 and the previous month's 54. IHS Markit’s Chief Business Economist Chris Williamson said that the flash PMI data was higher than the average of 54.0 before the pandemic and showed that the GDP grew each quarter 0.7%.

Markit reported that activity increased as the private sector growth reached a three-month high, with strong business and consumer spending. Service providers were the main driver behind the recovery. Employment numbers also rose as improved customer demand and confidence about the business outlook strengthened. Pressures from higher costs and staff shortages will however persist.

Retail Sales

Earlier on Friday, the ONS reported that UK retail sales fell in September. The pound dropped following the disappointing news, as it was shown that the economic slowdown might be worse than expected. Retail sales for September were down 2.6% year-on-year, lower than the expected 1.7%.

Even as we move into the Christmas period, higher gas prices will keep operating costs high and reduce consumer spending power.

November interest rate hike

The pound will also be at risk from the Bank of England disappointing markets and not proceeding as expected with the interest rate hikes. The markets now see a November interest rate hike (from 0.1% to 0.25%), as a 56% possibility, which is down from 90% earlier this week, after Bank of England governor Andrew Bailey suggested the BoE will have to act to control inflationary pressures.

BoE chief economist Huw Pill told the Financial Times that the Bank would have a "live" decision to make at its next meeting on the 4 November. While he declined to say how he would vote at the Bank’s meeting next month, he said "it is finely balanced": "I think November is live."

The UK interest rate has been at a historic low of 0.1% since March 2020. The view that November’s meeting is “finely balanced” may have encouraged traders to reconsider the odds of action next month.

GfK Consumer Confidence survey

Consumer confidence was also down in October, at its lowest since February. Consumers are concerned with the future of the economy. The possibility of a cold winter coming while dealing with fuel and food shortages, Brexit and surging inflation, as well as interest rates affecting the cost of borrowing, not to mention Covid-19 cases rising, does not sound especially promising. The Petrol Retailers Association (PRA) has said that all-time highs seen in April 2012 of 142p per litre for petrol and 148p for diesel will be surpassed by the end of October. Average prices for petrol and diesel had reached 141.35p and 144.84p respectively on Tuesday, according to Experian Catalist UK.

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With Bank of England policymakers signalling that the central bank is moving towards an early interest rate hike, traders have been trying to figure out what this means for the pound. Economists and forex analysts have offered both positive and negative comments about the bank’s intention to raise interest rates, with other analysts turning neutral. 

Interest rate rise could hurt the pound

Markets are now expecting the BoE to raise interest rates in November, with further rates to follow by the end of 2022. However, the link between higher interest rates and a stronger currency has been broken, unfortunately, due to the current energy crisis, higher costs and a struggling economy due to the pandemic. Within this environment, many analysts are concerned that an early rate hike will actually create more problems and that it could be reversed within two years, creating further uncertainty for the currency.  

Jane Foley, head of foreign-exchange strategy at Rabobank, said that “There is a lot of uncertainty,” in London. “It’s easy to argue that rates going up will strengthen the pound. But the risk of a policy mistake means the BOE could hike soon but then won’t be able to follow through” with more tightening.

Bank of England Policy Mistake?

Markets are unsure about the outlook for the pound, with institutional fund managers limiting their trades against the pound and others betting for the pound to strengthen. For some analysts, the BoE tightening will provide some support for the currency but, for others, the lack of economic growth will eventually reverse any gains.

Additionally, further challenges remain. Brexit tensions between the UK and the European Union over Northern Ireland could escalate into a trade war, but Prime Minister Boris Johnson has offer assurances that solutions will be delivered within the week.  

Despite the Bank of England’s Governor Andrew Bailey’s reassuring comments that the Bank will do what it takes as inflationary pressures rise, traders are concerned about the pound outlook in the longer term.

Pound remains “insensitive” to UK rate expectations

While many foreign exchange analysts have voiced their concerns about the pound outlook if the Bank of England proceeds to an early set of interest rate rises, HSBC strategists believe the pound is “insensitive to the continued hawkish drift in UK rate expectations.” Even if inflation falls at the end of 2022 and there is no need to raise rates higher on a long-term basis, HSBC says there is more to the pound than an automatic fixation on the BoE.

Indeed, the pound is not driven solely by the desire of the Bank of England to raise or not rates. A they argue, the pound’s performance has been mainly determined by global forces. It rises against the euro and US dollar on positive investor sentiment and falls when global markets struggle. As investors recently digested global concerns about the pandemic and the energy crisis, buying interest for the pound has returned, pushing Sterling higher.

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UK inflation has fallen slightly but remains above the Bank of England’s target. According to data from the Office for National Statistics (ONS), UK CPI inflation eased slightly to 3.1% in September, from 3.2% in August—the highest in nine years.

The pound softened on Wednesday morning following the inflation data, as analysts expected the September reading to remain at 3.2%.

The slowdown is mostly due to the effects of lower prices of dining out last month compared to last September, when prices rose following the end of the Eat Out to Help Out scheme.

BoE

The data comes after Bank of England Governor Andrew Bailey said that the central bank will have to act to ease inflationary pressures – raising expectations for earlier rate hikes. According to economists, the bank’s task is a difficult one, as it expects inflation to reach 4% in the current quarter, with higher interest rates expected to ease it. However, the economy is struggling with higher costs and rising commodity prices, which interest rates have no power over.

Inflationary pressures rise

The cost of UK company goods and services continued to rise last month, affected by the supply chain crisis. Output price inflation rose to 6.7% per year in September, from 6% in August. Inflationary pressures are building in the economy as producers increased their prices, passing on costs to consumers. Companies reported that input prices increased by 11.4% year-on-year in September. Manufacturers faced commodity costs and transport costs due to shipping issues and a shortage in lorry drivers.

Economists: inflation is temporary

Economists are warning that September’s fall in inflation will be temporary. Costs rose due to supply issues and the higher energy price cap. The persistent supply-chain disruptions and energy price effects could push inflation higher above 4% early next year.

Senior economist at Royal London Asset Management Melanie Baker, expects more inflation. He warned that energy bills could push consumer price inflation further, which will reduce real income growth for many and add to some of the economic challenges in 2022.

Paul Dales of Capital Economics predicts inflation to reach 5% next April, when Ofgem hikes the energy price cap again. He noted: “However, this feels a bit like the lull before the storm as the 12% rise in utility prices on 1st October will probably lift CPI inflation to around 3.8% in October. And we think inflation could then climb to around 5.0% in April next year due to a further rise in utility prices and the upward influence from global/domestic product shortages. With underlying wage growth and inflation expectations rising, the BoE is concerned that higher inflation will become embedded in the system. That’s why it become much keener to raise interest rates.”

Dales explained that he doesn’t expect interest rates to be raised as far as 1.00% by the end of next year, since higher inflation will weaken the outlook for activity and with supply shortages easing, inflation will eventually fall to around 2% by the end of next year.

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Sterling reached a 20-month high against the euro on Monday after Bank of England Governor Andrew Bailey sent another signal that the central bank is heading towards raising interest rates as inflation risks rise. On Tuesday, the British currency held on to its near 20-month high gains against the euro and has reached a new one-month high against the US dollar. The main factor supporting the pound is expectations the BoE will raise rates, with investors speculating on a rise to 0.25% by December, or even earlier by November. Traders will be focusing on the release of the UK CPI inflation data for September on Wednesday and Friday’s PMI data for further clues.

Despite the pound’s excellent performance, some foreign exchange analysts are wondering whether the recent gains can be sustained in the long term.  

Warnings

Many economists and analysts have warned that the Bank of England’s intention to return interest rates to pre-pandemic levels could be a huge mistake that will impact on economic growth and push costs higher for households that are already under pressure. Higher interest rates, combined with zero growth and high inflation will hurt both the economy and the pound.

Others have noted that the pound won’t be supported for a long time by the Bank of England’s higher interest rates due to persisting supply chain issues and a struggling labour market.

Former Bank of England Monetary Policy Committee Member, David Blanchflower, said that raising rates very soon will be a disaster and “foolish.” He told BBC Radio 4 that interest rates are at 0.1% but economists warn that inflation could peak at 6.0%. Former MPC member Andrew Sentance laughed at Danny Blanchflower’s comments saying that he did not understand monetary policy.  With economists being torn about the prospect of higher interest rates, it is not surprising that there are so many differing views. However, markets have priced in a rate hike and expectations remain solid that an interest rate hike is possible in November.

Bank of England has been Misunderstood?

At the same time, analysts argue that the BoE Governor’s recent comments have been misunderstood and that a November rate rise is unlikely. Bailey has stated that the Bank will act if there are inflation risks in the medium-term and that the Monetary Policy Committee will wait and see until December when labour market data is available.

Also, for some analysts, the subsequent rate hikes being priced in by investors are a bit extreme as possibly two rates maximum by the end of 2022 sounds more reasonable. However, any recent hike expectations being priced out could also negatively impact on the pound.

Others have argued that, if indeed early interest rate hikes will be disastrous to the economy, then pricing out these rate hikes will possibly support the pound.  With so many different arguments, it is not yet clear how the pound will react. Some commentators have even gone as far as to suggest that the pound will fall whatever happens. For example, if the BoE ends up being more dovish and does not raise interest rates, it will end up disappointing markets. On the other hand, if it does deliver early rate hikes it might end up making a policy mistake. Nonetheless, Friday’s PMI data might offer further guidance: if it comes stronger than expected then the pound will strengthen and so will the case for raising interest rates.

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The pound remains strong and is close to last week’s gains against both the euro and the US dollar following Bank of England Governor Andrew Bailey’s comment that the bank is intent on raising interest rates as inflation risks rise.

Many analysts have noted the benefits of an early rate hike, while others have warned about the impact of an early rate hike on UK growth prospects. According to foreign exchange analysts, the pound has found support from expectations that the Bank of England will be among the first major central banks to raise interest rates since the pandemic started.

Bank of England

Bank of England Governor Andrew Bailey said on Sunday the Bank of England intends to raise interest rates if inflation continues to grow. Speaking to the Group of 30, an international body of financial leaders, Bailey explained that UK inflation will be temporary, but rising energy prices will push it higher and for a longer period of time. Bailey said: "Monetary policy cannot solve supply-side problems - but it will have to act and must do so if we see a risk, particularly to medium-term inflation and to medium-term inflation expectations.” He also clearly stated: "We at the Bank of England have signalled, and this is another such signal, that we will have to act. But of course that action comes in our monetary policy meetings."

Some analysts believe that the shift in monetary policy will outweigh the negative effects of slow economic growth and will slowly push the pound higher.

Rabobank: Risks Ahead

The prospect of the pound rising next year and beyond could be hindered by fears around the medium-term outlook for the UK economy. Rabobank said: “Tensions with French fishermen and disagreements about the Northern Ireland protocol have brought warnings of a trade war between the UK and the EU. Neither had had a significant impact on the pound to date. That said, this is a risk that the differences between the UK and the EU won’t be resolved easily and, on the margin, this news-flow provides an additional disincentive to GBP investors.” They added: “We are not expecting the BoE to raise rates in the coming months and see scope for GBP to edge lower on disappointment.”

Next Interest Rate Rise

Money markets are now expecting a rate rise in November, and as many as three rate hikes in 2022. If the Bank disappoints and does not proceed to a rate rise, the pound will fall. At the same time, other analysts have talked of a Bank of England policy mistake as they believe raising interest rates would slow down growth. A more aggressive BoE tightening will push borrowing costs for households and businesses higher and will impact the UK housing market. Stagflation (no growth and high inflation) fears will add to concerns about the pound.

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Improved market sentiment has helped push the pound higher against the euro and the US dollar. Comments from two of the Bank of England's Monetary Policy Committee (MPC) members Silvana Tenreyro and Catherine Mann, who spoke out against an early rate rise, did not affect the pound.

Pound Rises

The British pound rose despite comments from the Monetary Policy Committee (MPC) member Silvana Tenreyo, who said the current rise in UK inflation is temporary and that it was early to raise interest rates.

In other news, the European Union threatened to retaliate if the UK abandons the Northern Ireland deal. Nevertheless, Sterling rose on improved risk sentiment.

Bank of England

Two of the Bank of England’s monetary policy committee members have said they prefer to wait and see how gas prices and shortages of raw materials will influence inflation before voting for an interest rate hike. Both economists highlighted that economic recovery remained uncertain.

• Catherine Mann

Catherine Mann, who is a former chief economist at the Organisation for Economic Co-operation and Development and the US bank Citi, said that it was best to wait and see as traders are currently betting on tighter monetary policy in the UK and US. Mann said that market participants were doing the bank’s job because by speculating on what the bank will do have driven the cost of borrowing in financial markets higher, which, as Mann explained, is what a rate rise would do. She noted: “They see that monetary policy normalisation is the direction of travel … and so they are doing their homework and they are starting to price in that direction of travel.”

• Silvana Tenreyro

Silvana Tenreyro was also against an early rate hike.  Speaking to BusinessLive Wales, she said even a rate rise could be “self-defeating” if inflationary pressures prove to be temporary. Tenreyro said that the current level of inflation was considered against last year’s low prices. Additionally, the surge in the global price of energy and other commodities pushed inflation higher but these are usually temporary. Tenreyro explained: “The prices go up, but they don’t keep going up sustainably, so you have a one-off price effect and in that sense inflation should be transitory. She also said: “By the time interest rates were having a major effect on inflation, the effects of energy prices would already be dropping out of the inflation calculation. If some effects were to prove more persistent, it would be important to balance the risks from a period of above target inflation with the cost of weaker demand.”

Many investors are speculating that the BoE will raise interest rates before the end of the year, becoming the first major central bank to raise rates since the start of the coronavirus pandemic.

Foreign exchange investors are interested to see how central banks will choose to act and when they plan to raise interest rates.

The Pound's rally higher despite dovish comments by Tenreyro, suggest that her views are already known and unsurprising and are not powerful enough to deter the majority of the Bank’s members raising interest rates. Some analysts expect an early rise to boost the pound, while others are arguing that a rate rise might be bad for the pound as it might raise costs at a time that growth is slowing down.

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Brexit might had gone away for a while, replaced by more prescient concerns such as the pandemic, slower economic growth, supply chain issues and higher inflation, but it is making a comeback. Tensions between the EU and UK over the Northern Ireland agreement could put an end to potential gains, analysts gave argued, while inflation worries could also put more pressure on the currency.

A weaker US dollar and falling US Treasury yields have also helped both the euro and pound rise. Despite higher wages in US inflation data and rate hike expectations, the US dollar fell from Wednesday’s almost one-year high.

Bank of England: First to raise interest rates

The pound was higher yesterday following data that showed the economy grew 0.4% in August, 0.8% smaller than February 2020, the Office for National Statistics said. Economists were expecting a monthly gross domestic product growth of 0.5% for August. The biggest impetus for the pound is the expectation that the BoE will be the first central bank to raise interest rates since the start of the pandemic, with some investors expecting a rise to 0.15% by December.

Sterling was at a two-week high on Monday due to weekend headlines that Bank of England governor Andrew Bailey, and MPC policymaker, Michael Saunders, warned of inflationary risks and the need to act, raising interest rates earlier and preventing inflation from becoming permanently embedded.

Analysts believe that the Bank of England's move towards raising interest rates will push demand for the pound higher. However, other analysts have argued that moving too early might risk economic growth, especially at a time when the growth outlook is subdued.

Brexit

The positive news that Brussels plans to reduce checks on goods entering the region has done little to provide fresh impetus to the pound. The new plan, which seeks to resolve a dispute over a key part of the Brexit agreement, would remove about 80% of spot checks, while customs paperwork would also be cut by 50%.

However, UK Brexit Minister Lord David Frost’s demand to rewrite the Protocol to remove the oversight role of the European Court of Justice (ECJ) might create further tensions.  On Wednesday, a UK government spokesman said both sides should start a new round of "rapidly conducted" talks to tackle such issues as governance, since a solution needs to be found that protects the Good Friday Agreement and strengthens the relation between the EU and UK.

Democratic Unionist Party (DUP) MP Ian Paisley told the BBC that Prime Minister Boris Johnson told him "personally that after agreeing to the protocol he would sign up to changing that protocol and indeed tearing it up, that this was just for the semantics".

Talks between the EU and UK on the new proposals might last for several weeks. Any renewed tensions and disagreements could spark more pound volatility.  

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The pound is not expected to rise higher from current levels, analysts have said.  Brexit tensions and an early interest rate hike by the Bank of England could eventually push the pound lower. Barclays warned of possible Brexit tensions rattling the foreign exchange market, while HSBC analysts said that the pound is not cheap and that there are significant risks to the UK outlook.

HSBC analysts

HSBC currency analysts believe that the pound should have been higher than current levels, considering market expectations for an earlier rate hike. The fact that the British currency has failed to advance despite these developments, suggests that political risks are returning to the currency.

HSBC analysts do not see scope for further Sterling gains, as the pound faces opposing forces including growth, inflation, rate expectations and external balances. They argue that the pound’s trajectory will become clear once one of these forces dominates the other. The bank said that Sterling could gain in the near-term due to the Bank’s expected rate increases but this would be offset by a deteriorating economy as the Bank’s monetary tightening fades quickly. The high energy costs combined with higher inflation will slow economic growth, the analysts added.

• Brexit vote and financial crisis

HSBC noted that the pound has been deeply affected by the Brexit referendum in 2016 and earlier by the 2008/9 financial crisis. Both events have influenced the fair value assessments of the pound and they argue that currently the UK currency is closer to fair value and even expensive against other currencies.

• Inflation

HSBC bank notes that the UK is expected to grow at a slower pace while exhibiting the highest inflation in over a decade, with fears of stagflation hurting the pound. In a survey conducted by Barclaycard, 90% of the shoppers said they were concerned that rising costs of everyday items would affect their household finances.

Barclays

Barclays analysts are also concerned with the pound outlook as they have pointed out that tensions between the EU and UK over the Northern Ireland protocol could negatively impact on the foreign exchange market. Failure to reach an agreement might result in the UK triggering Article 16 of the protocol, triggering retaliation measures by the EU such as tariffs and impacting on the Trade and Cooperation Agreement (TCA). Any such scenarios will hurt the pound.

Britain wants to negotiate a “new protocol” to regulate post-Brexit trade in Northern Ireland, Britain’s Brexit Minister David Frost said in Lisbon on Tuesday. Ahead of the European Commission's formal response to the UK’s plan, Lord David Frost said the EU would be making a “historic misjudgement” if it refused to rewrite the Brexit deal covering trading arrangements for Northern Ireland. Brussels has warned the UK that they are not in a position to indulge themselves in important renegotiations.

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