The pound was up against the euro on Wednesday, strengthened by higher UK bond yields and expectations of an earlier interest rate hike by the Bank of England. Sterling rose to a three-week high against the euro yesterday, as traders returned their attention to the prospect of interest rate hikes in Britain. The pound was down last week, due to rising inflation concerns, but it has now recovered.

Sterling’s recovery is mainly due to the prospect of the BoE raising interest rates sooner than expected, but analysts have commented that the pound should have risen even higher especially because of the important difference between the European and UK central banks. While the BoE has clearly stated its intention for an earlier rate hike, the European Central Bank has no plans to raise rates soon. Economists have warned that caution should be exercised though, as the pound’s gains might not be long-lived. It is still unclear whether the BoE will proceed to raise interest rates while the UK is facing ongoing supply problems.

Inflation

On Tuesday, British Prime Minister Boris Johnson said inflation fears were baseless. The final reading of the IHS Markit/CIPS composite Purchasing Managers’ Index showed that companies increased prices at the fastest pace on record, following shortages of staff, raw materials and transport.

Brexit

The pound has yet to react on Brexit risks after the UK told the European Union on Monday it would  “trigger safeguard measures in their divorce deal if the bloc failed to agree to changes to smooth trade with Northern Ireland.” Speaking at the Conservatives' annual conference in Manchester, Brexit minister David Frost stated that "Without an agreed solution soon, we will need to act, using the Article 16 safeguard mechanism, to address the impact the protocol is having on Northern Ireland." The EU is putting together a package of measures to ease the passage of goods from Britain to Northern Ireland, using flexibilities in the protocol, which will announce next week.

Tighter policy could weaken pound

Goldman Sachs Asset Management has said that tighter policy could weaken Sterling. The firm’s strategist for the global fixed income team said that high inflation and energy prices, and Brexit implications could further complicate the inflation outlook. Fears of higher inflation combined with the ongoing supply-chain crisis and an end to the government’s furlough program have worried investors who believe the BoE may choose to raise interest rates sooner than necessary, risking economic recovery.

Other firms and financial analysts are less concerned as challenges are not seen as dangerous and are merely transitory. They don’t believe that the Bank will be forced into a dangerously fast pace of tightening.

What to watch

A key indicator to watch is the UK's labour market as unemployment is expected to increase in October since the government's job support scheme ended on the 30th of September and furloughed staff might not be able to return to their old jobs. The furlough scheme which started in March 2020, supported 11.6 million jobs across the UK and government figures suggest that around a million people were still on furlough when it ended.

If unemployment is lower than expectations, the consensus is that the Bank could move towards a rate hike as a strong labour market will increase the potential for wage rises which push inflation higher.

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The pound is expected to stabilise and rise further according to analysts as investor sentiment is strengthened and the Bank of England is moving toward tightening its policy next year.

The pound stabilised against the euro but remains to be seen how well it will perform against the dollar as Friday’s jobs report will determine the outcome.

Pound is in recovery mode now

The pound dropped last week after concerned investors sold Sterling against the euro and the US dollar fearing higher inflation following the global energy crisis. Higher gas prices and panic-buying at petrol stations due to a shortage of lorry drivers, signalled weakening economic growth and hurt market sentiment. By the beginning of the new month, however, Sterling managed to recover, as analysts noted that perhaps the currency overreacted to the fuel crisis in the UK.

The pound rose, leaving behind last week’s losses boosted by Thursday’s release of UK GDP data that showed the economy grew more than expected in the second quarter. This will also offer more evidence that the economy is growing, and the Bank of England is on track to raise interest rates in early 2022.

Sterling is a good buy

Analysts believe that due to its long-term undervaluation, the pound is an attractive investment. In general, economists believe that economic growth will continue, and the economy will return to its pre-pandemic levels in the first quarter of 2022, earlier than anticipated.

Many currency strategists believe that the pound will also strengthen against other major G10 currencies in the short term and even for longer against the euro. The Bank’s earlier raising of interest rates and policy tightening will prove to be fundamental to the British currency’s performance.

If investors find the currency appealing due to its rate, then this will offer further support to the currency. However, global developments that could influence the pound remain a constant risk for Sterling. As we have noted in the past, the pound is sensitive to global economic sentiment and tends to depreciate when global stock markets fall. With concerns about global economic growth weakening and inflation rising, it is not unsurprising if the pound reacts with more volatility.

Higher inflation remains a constant risk for the pound

Economists said that higher inflation in major economies will lead to the gradual depreciation of those countries’ currencies. For example, the US and the UK, along with Canada and Australia are at risk of prolonged higher inflation, which might weaken their currencies compared to other countries in Asia or Europe where inflation remains within normal levels. Talking on Tuesday during an interview, Prime Minister Boris Johnson, said that inflationary pressures will subside as supply increases. He stated: “What you are seeing is demand, growing demand sucking in gas from Russia or wherever, you are seeing demand for lorry drivers globally and that has an inflationary effect and as that clears, as supply meets demand then inflation abates."

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The pound could rise against the euro due to the Bank of England’s optimistic stance as interest rates are now expected to rise earlier than previously anticipated. The pound was also pushed higher as traders looking for a good offer bought a cheaper pound. According to analysts, the pound could reach new highs by the end of this year.

Bank of England and Rate hike

While last week, the pound fell due to inflationary concerns, over the weekend it was higher. With limited economic data the week ahead, the pound will be likely influenced by more news on the fuel crisis, but analysts expect it to remain supported on BoE’s interest rate prospects. The Office for National Statistics has also upgraded its second quarter GDP growth forecast from 4.8% to 5.4%. With the Monetary Policy Committee of the BoE expected to raise the bank rate to 0.25% in May and one more time in 12 months, markets are optimistic.

In a speech that was given to the Society of Professional Economists annual dinner, the Governor of the Bank of England said: “All of us believe that there will need to be some modest tightening of policy to be consistent with meeting the inflation target sustainably over the medium term. Recent evidence appears to have strengthened that case, but there remain substantial uncertainties and we are monitoring the situation closely. The BoE policymakers would need to see clear evidence that the labour market is thriving and employment activity is back to normal levels before taking any action.

Labour market possible scenarios

The BoE governor in his speech, outlined three potential scenarios for the labour market, highlighting the uncertainties ahead, as each of these could influence growth, inflation and monetary policy in different ways. The first scenario revolves around the furlough scheme and how after the furloughed workers return to their old jobs, we are still left with an excess of job vacancies. If these vacancies are linked with shortages of workers in particular sectors, this could push wages higher. This situation could raise the rate of unemployment consistent with stable wage growth. In a second scenario, where demand rises over time, vacancies and unemployment could fall. In the third possible explanation, advertised vacancies could be higher, but some of these could turn out not to be jobs as employers change their mind or postpone hiring.

Tightening monetary policy and bank rate

Governor Bailey has characteristically said that despite uncertainty, the stimulus program will need to unwind, and this will be coupled with an increase in the bank rate. He said: “For most members of the MPC, the outlook for the labour market – as I described earlier – is highly uncertain and to some degree likely to be resolved in fairly short order, and this justified a wait and see approach on policy in view of the continuing belief that higher inflation will be temporary. Within this view, some members put more emphasis on the continuing shortfall in the level of GDP relative to pre-Covid, while others emphasised the continuing direction of travel towards closing that gap and the evidence of cost pressures accompanying the closing. But all of this group were of the view that the stimulus to monetary policy enacted in response to Covid would need to start to unwind at some point, that unwind should be enacted by an increase in Bank Rate, and if appropriate would not need to wait for the end of the current asset purchase programme.”

This means that the Bank is expected to normalise its policy in early 2022 which could support the pound. Analysts view the pound’s recent weakness as temporary and expect it to strengthen in the long-term.

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The pound fell and remains vulnerable to global growth concerns and the ongoing fuel crisis in the UK as analysts fear of a difficult winter ahead. The fuel crisis has sparked concerns that growth will slow down, while rising inflation will aggravate problems. The panic buying of petrol was the result of fears regarding supply chain issues as the UK is struggling to recover from the Coronavirus pandemic.  

150 soldiers prepared to drive tankers

UK business secretary Kwasi Kwarteng has said that military tanker drivers are ready to help with the fuel crisis and transport petrol to stations, as 150 soldiers will be driving tankers within a few days. Despite calls to motorists to stop panic-buying at petrol stations, queues have continued. Kwarteng admitted that the last few days have been difficult, with large queues, but the situation is stabilising and that with soldiers driving the tanker fleet and getting petrol into the forecourts, things will return back to normal soon. In regard to issues in the run-up to Christmas, where people are busier, Kwarteng explained that it was difficult to make any predictions, but, nonetheless, he reiterated that the “situation is stabilising.”

The fuel crisis has generated more concerns about who will have priority access and many unions have requested that doctors, nurses and other essential workers to be given priority access to fuel. The Prime Minister has resisted this. The worst shortages have been experienced in London and English cities with fights and, in one incident in south London, a driver pulling a knife.

The supply chain issue and the shortage of lorry drivers is linked to Brexit and the government has said that it will deal with the driver shortage by providing temporary visas to 5,000 foreign drivers.

Bank of England to raise interest rates

The Bank of England will be forced to raise interest rates to fight inflation. Markets are concerned about the Bank having to tighten its policy against a weak background, with analysts describing it as a “stagflation story.”

The UK is especially vulnerable as it appears to be the hardest hit by the energy and supply chain crisis. The energy crisis is affecting economic activity, while the rising gas prices are a real issue for the currency. With the ongoing energy crisis, the pound will remain under pressure, and once it clears it will be able to stabilise. The gas price surge is also a global phenomenon as Asian countries are also competing for the same supplies. Growing fears of an energy shortage in China have led to Sinopec, an LNG importer, to outbid European competitors.

Traders and analysts are now focusing on the fuel crisis as they are worried about how the UK economy will fare and whether the current crisis is temporary or will last longer.

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The pound was stronger yesterday but dropped slightly today following the fuel crisis. The government has the army on standby to help ease fuel supply problems following days of long queues, panic-buying and pump closures. Analysts warn that this will only offer temporary relief, and that the UK needs to do more to more find a more long-term and viable solution to its current HGV driver shortage.

Analysts have noted their concerns about the impact of fuel shortages on everyday life, soaring energy prices and labour shortages which could eventually dent the UK’s economic recovery.

Petrol supply

Fears of driver shortage hitting fuel supply has led to a surge in demand with up to 150 military tanker drivers ready to deliver to petrol stations which have run dry because of panic buying. There is no shortage of fuel, but simply a shortage of fuel in petrol stations, due to a lack of lorry drivers. While this was expected to have minimal effects, the problem has been exacerbated due to the behaviour of motorists who have rushed to stations panic-buying fuel. The transport secretary Grant Shapps said there were "tentative signs" of stabilisation in petrol stations and the Petrol Retailers Association said that the number of motorists at petrol stations was beginning to calm. As Shapps noted, "Once we all return to our normal buying habits... the quicker we get back to normality." The UK is short of more than 100,000 lorry drivers which has affected many industries, especially food suppliers and supermarkets.

In a joint statement, fuel companies, including BP and Shell, have reassured the public that supplies have not been affected and that demand will return to normal levels.

Higher Inflation Could Help the Pound Rise Higher

In the meantime, the pound is expected to rise as inflation pushes higher and the BoE is forced to raise interest rates. Higher inflation is the result of a combination of factors, including supply shortages and shortages of HGV drivers. While the central bank has stated that inflation is only temporary, there are concerns that it will remain high for a longer period of time.

Bank of England Governor Andrew Bailey has expressed his concerns about the current issues with supplies that have pushed inflation higher, and he noted that the Bank is ready to act if this becomes a long-term issue. He said that higher inflation can be dealt with higher interest rates and that a rate rise before the end of this year is not impossible.

The rising energy prices that have pushed inflation higher are a major concern in the UK, and the question is whether more persistent inflation than expected will prove to be the case and how the Bank of England will change its monetary policy to respond to this. The Bank of England last week warned that their forecast for high inflation at 4.0% will be exceeded. In August, the Bank raised their peak forecast from 3.0% to 4.0%.

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The UK’s supply problems could push the pound lower despite that the market has priced in more interest rate hikes by the Bank of England for next year. The government has offered temporary visas to fuel tanker and food lorry drivers, and to poultry workers. Britain's ongoing supply chain crisis could threaten the UK’s economic recovery, and combined with higher inflation, it could post serious risks to the pound.

Visas to lorry drivers

With Christmas just around the corner, the government is seeking to avoid disruption and will provide up to 10,500 lorry drivers and poultry workers with temporary UK visas. 5,500 poultry workers and another 5,000 fuel tanker and food lorry drivers will be allowed to work in the UK for three months, until Christmas Eve. The Road Haulage Association said the government’s announcement "barely scratches the surface", and that just offering temporary visa for a limited period "will not be enough for companies or the drivers themselves to be attractive." Director of the HGV Recruitment Centre, Marc Fels, said visas for lorry drivers were "too little" and "too late." The move is, however, a huge step forward in providing a temporary solution to supply chain disruption. The government has also requested from the Ministry of Defence examiners to increase HGV (heavy goods vehicle) testing capacity and sent one million letters to drivers who have an HGV licence to return to the industry. 

Various industries such as supermarkets and food chains have reported shortages of lorry drivers, while fuel deliveries have also been affected, with queues at petrol stations as consumers are panic buying despite calls from the government that the UK has plenty of fuel.

Petrol Crisis

Transport Secretary Grant Shapps has stated there was enough fuel and that people should only fill up when needed to avoid creating shortages. He said there were no supply problems at the six refineries and 47 storage facilities, and that drivers and motorists needed to “be sensible.” With the petrol crisis deepening, ministers have been forced to suspend competition law to help oil companies support petrol stations that are running dry, after days of panic buying. Following a meeting with oil companies on Sunday, business secretary Kwasi Kwarteng agreed to allow companies in the oil industry to work together, sharing information to keep petrol stations topped up.

The panic buying and shortage of drivers has also led the government to consider an emergency plan. The prime minister and senior members of the cabinet will examine “Operation Escalin” after BP reported that a third of its petrol stations had run out of the two grades of fuel, and the Petrol Retailers Association (PRA), said that 50% to 90% of its members were also running out, with more to follow.

Operation Escalin was first conceptualised as part of the planning for a no-deal Brexit, and involves  hundreds of soldiers being drafted in to drive a reserve fleet of 80 tankers. The Prime Minister will consider the Escalin and other proposals on Monday afternoon, in a meeting where ministers will also discuss ways to stop people from panic buying. Shortages could continue if people’s behaviour did not change.

The UK could also face a national shortage of turkeys in the run-up to December, with labour shortages due to Brexit.

 

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Despite Sterling rising yesterday following the Bank of England’s positive tone and the prospect of an early rate hike in 2022, on Friday it fell.

Asian and European stock markets were also down on Friday as well as risk-oriented currencies as the potential default of Evergrande can have significant repercussions on markets.

Pound and BoE

After the Bank of England’s meeting on Thursday, markets have brought their expectations forward as now the BoE is expected to start a rate hike cycle with a first increase in May 2022, followed by a second one in November 2022. While there are still uncertainties ahead for the pound, the British currency is still forecast to strengthen against the US dollar and the euro over the medium-term, as some analysts believe.  

Rate hike expected in early 2022

With markets now pricing in the first rate in the first quarter of 2022, the pound will find support, despite questions about the country’s economic recovery. Challenges will continue to exist, including unemployment and labour shortages that have become more prominent due to Brexit. Some analysts believe that if unemployment does not rise then the Bank’s Monetary Policy Committee could even add a small rate hike as soon as February. With market expectations for a rate hike already priced in, it is likely that the Bank will have to raise rates in early 2022 as it could otherwise create confusion and push the pound lower. For example, big banks such as JP Morgan have brought their expectations forward for a rate rise in early 2022 following the Bank’s announcement yesterday. Capital Economics said: "The Bank is moving closer to raising interest rates. As such, we now think that rates could rise in early 2022, rather than in 2023 as we had previously thought." They also added: "Given the gloomy tone of the recent news on economic activity, we had expected the MPC to place some weight on the downside risks to GDP growth.” However, the Bank’s minutes stressed price stability and the inflation target which remains the same. The Bank highlighted that growth uncertainties were external and depended on global supply chain limitations.

For Sterling, any news about when the rate hikes will start or the vote on QE will be key. Both Dave Ramsden and Michael Saunders voted to lower the purchase rate to £840bn instead of the £875bn. The fact that two policymakers want to tighten the policy is important.

Earlier interest rate hikes will offer more support to pound

With interest rate expectations and a first rate to take place for Q1 next year, the pound is expected to find support. It could rise even further if such expectations move even more forward.  While raising interest rates might not affect inflation, what other Central Banks do does have an effect on global markets and policy. The ECB and the Federal Reserve have both announced that they will begin the tapering and reduce their stimulus support, and if the Bank of England does not follow suit the pound could go lower, something that could push inflation to rise and import prices to go higher.

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The Bank of England remains on track to raise interest rates in the first half of 2022. The pound rose against the euro and US dollar following the bank’s update to keep rates the same. The Monetary Policy Committee voted 9-0 to leave the Bank rate at just 0.1% and to maintain its quantitative easing bond-buying programme at £895bn. Deputy governor Dave Ramsden and Michael Saunders, voted against this, as they wanted to stop the QE programme early by reducing the amount of UK government bonds the BoE buys. While the bank was not 100% yet positive as there are uncertainties about the global economy and the labour market, the pound is expected to regain some of its losses but not to climb to new highs.

According to Bloomberg, City traders have revised their forecast for the first interest rate to 0.25% after the Bank of England’s outlook for the UK economy has improved and that tightening of its QE programme could commence soon.  After Thursday’s meeting, markets now expect a 15-basis-point increase in March 2022, a month earlier than their expected one for May. They also expect a rise of 0.5% in November 2022. With markets now pricing an increase in March and two hikes by the end of next year, investors will be focusing on the bank’s November meeting when a new set of forecasts will be announced.

Inflation

The Bank of England has warned that inflation will rise above 4% by the end of this year, due to the energy crisis. The rise in gas prices is considered a risk to its projections for inflation and it has warned that inflation could remain above 4% into the second quarter of next year making things harder for households. The MPC expects that global cost pressures would prove temporary.

Growth forecasts lowered

The Bank of England has lowered its growth forecasts as supply chain problems are impacting output. Expectations for growth in the third quarter have been revised from 2.9% to 2.1%. The Bank has warned that supply problems such as access to raw materials and staff shortages are affecting economic growth. The Bank also highlighted that global recovery has lost momentum and inflationary pressures will continue.  

Tightening monetary policy

The case for tightening monetary policy seems now stronger. Consumer price inflation rose to 3.2% while global cost pressures and supply problems are pushing consumer goods prices higher. CPI inflation is expected to fall back to the bank’s 2% target in the medium term, but the bank has also pointed out that: “Indicators of households’ medium-term inflation expectations have increased in recent months, with the Citi/YouGov five-to-ten year ahead measure at its highest level since 2013 in September.”

The BoE is also under pressure, as other central banks such as the ECB and Federal Reserve have announced that they will begin unwinding their financial support. If the BoE does not act in the same timeline, Sterling could fall, pushing inflation and prices higher. A rising pound will push the cost of imports lower and will act as a deflationary force.

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The pound was lower on Wednesday after investors became less confident about an earlier rate hike by the Bank of England, which is now likely to be delayed due to weak economic data. A weak US dollar and a stronger risk sentiment following news that Evergrande would repay a yuan-denominated bond on Thursday have not helped to support the pound.

Risks for the pound

The main event for the pound this week is Thursday’s Bank of England decision, and investors seem to have moved from expecting a hawkish BoE to grasping the fact that an interest rate hike is now more than six-months away due to the release of disappointing economic data. The currency market is expecting at least two rate hikes by the end of 2022, but now such expectations are considered too optimistic. With the market pricing the fact of an earlier interest rate for some time now, the realisation that the tables have turned, and a rate hike might take a while longer, means that the pound could react by falling. Sterling could find support if the BoE clarifies its timeline for raising rates starting early next year, but this is unlikely, analysts have noted. The Bank’s expectations will also be shaped by the health of the labour market, especially after the furlough scheme is completed at the end of this month, and analysts expect unemployment to rise. The BoE will also take into account disappointing data for July, retail sales’ numbers in August, and high inflation.

The pound was also weaker against the euro as investors are waiting to hear form the Federal Reserve any hints on the direction it will take for its future policy, including whether it will start tapering its bond buying by November.

Factors that could support the pound

The possibility of Britain joining the North American free trade deal, an idea that has been shared by media, could boost UK-US trade and help offer support to Sterling. As a UK government figure said, the UK is interested in pursuing this option but “The ball is in the US’s court. It takes two to tango.”

The trade partnership between the US, Canada and Mexico, is now a possibility after Boris Johnson failed to secure a bilateral deal with Washington. It appears that a direct free trade agreement (FTA) with the UK is not something that the president Joe Biden will be interested in pursuing and the Prime Minister said that Biden “has a lot of other fish to fry.”

The UK government’s interest in joining the North American deal follows the opening of talks for the UK to become a member of the CPTPP Pacific trade group. The likelihood of Britain joining NAFTA is an attempt to secure a tariff-reduction deal as new barriers have been erected to trade with the EU with Brexit.

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The beginning of the new week has seen the pound fall as market sentiment deteriorated following fears the Chinese property sector will suffer from the Chinese mega developer Evergrande’s collapse. Additionally, fears of a global economic slowdown and a gas crisis have left the market in a risk off mode, with the pound lower against the safe havens of the US dollar, Yen and the Franc. Sterling was also lower against the euro and commodity currencies including the Australian dollar, New Zealand dollar and Canadian dollar.

Energy markets

The UK’s wholesale energy markets have risen recently due to a global increase in demand for gas after a prolonged cold winter that left gas storage facilities depleted, with increased energy demand across Asia. Prices have surged as a result of a global attempt to refill gas storages before the winter.

With half of the UK’s electricity coming from gas-fired power plants and a rising demand for gas power after a series of nuclear reactor outages and the recent closure of a major power cable that brings in electricity from France, the situation has generated concerns about the coming winter months.

The UK government is also taking part in discussions about a possible financial bailout to energy providers. Kwasi Kwarteng, the Business Secretary, has been in various meetings over the weekend and will continue to meet the heads of energy businesses this week, to explore the possible options amid warnings that many companies could go bust. One of the potential solutions that have been discussed is a bail-out fund and the industry is now fearing a financial collapse according to the FT.

Following his emergency meeting with energy companies on Monday, Kwarteng  tweeted that he will update MPs this afternoon, and that the government is looking at different options to protect customers and to they have continuity of supply if their supplier fails, through a “Supplier of Last Resort” or a special administrator if needed. The energy price cap will remain in place he confirmed. A spokesman for the Prime Minister told reporters: “The price cap remains in place, as I say, to protect consumers from sudden increases in global gas prices and it will save them money this winter.”

With the possibility of millions of customers being unable to be served by failing companies, supply energy companies are requesting support from the government, and a "Northern Rock-style bad bank" could be created to house such customers without losing money.

BoE

The gas crisis comes ahead of Thursday's Bank of England policy meeting which is a crucial event for the pound. The Bank could warn the gas crisis could slowdown growth and possibly push back the timing of an interest rate hike.

Evergrande

Another event that has rattled the markets was the news that the Chinese mega developer Evergrande is heading for a corporate restructuring that could see investors lose tens of billions of dollars. Shares in Evergrande have plunged 17% and the group’s massive debt problems could trigger a broader sell off across all financial markets. Evergrande's importance to the Chinese economy is huge, as its debts amount to around $447 billion (US$315b). This is more than three times the entire debt load of the New Zealand government and two-thirds of all outstanding Australian federal debt.

The rising natural gas prices and the energy crisis, the potential of produce shortages and surging inflation have already painted a rather dire image of the global economy. The Fed’s meeting this week and the German election create further uncertainty.  Monday’s major shock for the markets came from Evergrande’s meltdown and investors could possibly avoid China. These are now being factored in by the markets, and it will be especially revealing to see how the Fed will position itself in terms of another rate hike amid inflationary pressures.

The pound has hit a four-week low this Monday as investors turned to safer assets, but GBP currency traders will be looking at this Thursday’s BoE meeting for more guidance.

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