The pound has grown stronger against both the US dollar and the euro, due to a weaker US dollar following a drop in US consumer sentiment in November and sliding US Treasury bond yields. The positive sentiment in the financial markets helped boost the pound and weaken the safe-haven US dollar, but hawkish Fed expectations will likely limit the greenback’s losses.

Apart from this, the possibility of Britain triggering Article 16 and suspending parts of the Northern Ireland Protocol could push the British pound lower. However, foreign exchange analysts at Barclays have said that Brexit tensions relating to the Northern Ireland protocol have not impacted on the UK currency yet, as the two sides seem to be closing in on an agreement and any major confrontation will be avoided. The EU’s lead negotiator, Maroš Šefčovič, said on Friday that a deal could be agreed this week.

Pound strength

The pound’s strength demonstrates, as analysts have suggested, that concerns about a trade war between the EU and the UK if the UK triggers Article 16 have not affected the currency market. Although some analysts believe that the pound will suffer in the event of Article 16 being triggered, others have said that the market is not so much influenced by Brexit tensions as risks of a no-deal are exaggerated. Barclays, for example, expects that a possible scenario would be a trade war or a no-deal Brexit, but both would take time to happen due to legal challenges and notice periods.

While a trade war between the UK and EU would affect the economy, this will not stop the Bank of England from raising interest rates at its December Monetary Policy Committee meeting. The Bank has lowered interest rates or kept the lower for longer in the past when sentiment regarding Brexit deteriorated. In general, if the Bank is more subdued in regards to Brexit, then the impact on Sterling will be limited.

Barclays expect a moderate escalation towards a "trade war" with economic costs to be more complex in the long term. Brexit will impact on GDP, with increased tensions and shortages, as well as decreased trade and productivity.

Triggering Article 16: An all-out trade war?

The UK has threatened to trigger Article 16, which provides a safety net in the Brexit arrangements and ensures that trade between Great Britain and Northern Ireland will be smooth while avoiding a hard border with the Republic of Ireland. Prime Minister Boris Johnson has rejected the European Union’s proposals as he wants to rewrite arrangements agreed to in years of negotiations. If the government does trigger Article 16, the worst-case outcome could be an all-out trade war.

Article 16 which is a clause in the Northern Ireland Protocol, agreed in October 2019, sets out the process for taking unilateral safeguard measures if either the EU or UK decides that the deal is leading to serious issues or a “diversion of trade.” Such safeguards will mean suspending parts of the deal. A trade war, industry leaders have pointed out, could have devastating effects on the economy, hitting British exports and disrupting supply chains. How much this will affect the currency market remains to be seen, but markets are more optimistic for the time being.

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Tensions between the EU and Britain over the Protocol on Ireland/Northern Ireland could create potential headwinds to the British currency. The pound fell last week following the Bank of England's decision to keep interest rates unchanged, and markets are now putting their hopes on a February hike. However, any upside potential will be hindered if the EU and the UK do not resolve their disagreement. Already, the EU has issued warnings if the UK triggers Article 16 of the Irish Protocol, while fears of a trade war between the two are growing stronger.

On Wednesday morning, Tánaiste Leo Varadkar warned British prime minister Boris Johnson that triggering Article 16 would be a “very aggressive and bombastic move” and noted that the UK will not end up with a better deal by doing so. Varadkar said: “The message I’d send to Boris Johnson is that we have an agreement in relation to Northern Ireland, we have an agreement in relation to trade with the European Union - don’t jeopardise it.” He added: “You were part of negotiating it, you own it, it was hard won, it’s a mistake to think that by escalating tensions or by trying to withdraw from any part of it, that you’ll end up with a better deal: you won’t.” Triggering Article 16 would allow the UK to suspend all, or part, of the treaty and will undo the Brexit deal resulting in the collapse of relationships.

Foreign exchange markets could build a premium into Sterling exchange rates as uncertainties over the future trading relationship between the UK and EU continue, posing considerable risks to the currency.

What is Article 16?

Article 16 is a clause in the Protocol on Ireland/Northern Ireland, which is an important part of the Withdrawal Agreement. The Protocol was created in order to avoid a hard border between British-ruled Northern Ireland and EU member Ireland by introducing some checks on the movement of goods to Northern Ireland from mainland Britain. Article 16 allows the UK or the EU to take action if they believe the Protocol will lead to "serious economic, societal or environmental difficulties."

The EU has cautioned Britain that triggering Article 16 would hurt relationships with the EU and destabilise Northern Ireland. By reopening the Protocol will create further complications regarding peace in Northern Ireland and protecting the EU's single market.

Brexit troubles will hurt the pound

The tensions between the EU and the UK and the prospect of a trade war over Northern Ireland will create potential risks to the pound. Financial analysts and strategists are cautious and believe the pound will trade with a more defensive tone as markets expect the UK government to trigger Article 16 of the Northern Ireland Protocol during the second half of November.

Markets will also be watching Friday’s meeting between the chief negotiators David Frost and Maroš Šefčovič.

Brussels Correspondent for BBC News, Jessica Parker, has reported that according to an EU diplomat the talks are rumoured to have been "extremely bad".

A worst-case scenario for the Pound would be the complete termination of the post-Brexit trade agreement, but this will be unexpected and a very extreme scenario. More likely, the EU could trigger legal proceedings and potentially impose tariffs on certain goods.

 

 

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The pound has been lifted from its lows after the Bank of England disappointed markets by keeping interest rates unchanged. On Tuesday, the pound was higher as investors are now focusing on a February rate rise.

While speaking at a virtual event organised by the Bank of England (BoE), Governor Andrew Bailey stressed that they will have to act and raise rates if they see a clear indication that higher inflation is feeding into wages. His comments did not impact on the market pricing of a rate hike in December. The CME Group's BoE Watch Tool shows a 67.5% chance of a 20-basis points rate hike before the end of the year.

In terms of Brexit, the ball is now in the UK’s court. After the EU clarified that they will act accordingly if Britain were to trigger Article 16, they are now waiting for the UK to make the next move.

Economic growth and Bank of England

The Bank of England’s dovish turn and less aggressive policy is in line with market data and suggests that their interest rate decision was made based on a more restrained and conservative economic growth outlook. The Bank lowered its 2021 growth forecast to 6.7% from August’s 8.5% forecast but raised the 2022 GDP forecast from 2.3% to 2.9%. 2023's forecast has been lowered to 1.1% from 1.3% that it was previously.

Inflation

Inflation is expected to go over the 2.0% target in the coming months and the Bank could act by raising interest rates if it deems appropriate. Bank of England Chief Economist Huw Pill said on Friday Nov. 05 that he believes the pace of wage inflation will surpass both those of the Eurozone and the US.

A more measured Bank means that there are less risks for early tightening, especially if inflation proves to be transitory. This will also support economic growth and households which are already struggling with higher costs.

Economists do believe that the Bank of England will still raise interest rates to fight inflation in the near future, as they expect hikes in December and February.

Other possible factors to consider for pound volatility

  • As a procyclical currency, the pound goes up when global stock markets are strong and falls when they fall. If the pound weakens it is usually against stronger safe havens such as the US dollar, the yen and the franc. For now, market sentiment is positive, and this has given fresh impetus to the pound.
  • Brexit tensions are growing, and this could potentially impact the pound. Ireland’s foreign minister Simon Coveney warned that the EU-UK Trade and Cooperation Agreement could be dismissed if the UK triggers Article 16 and rewrite the protocol on Northern Ireland. The protocol, which is part of the EU-UK withdrawal agreement, was agreed in order to avoid a north-south trade border on the island of Ireland. Protestant Unionist parties have rejected the agreement, and two buses were set on fire in the past week. If the UK fails to maintain a border in the Irish Sea, then this will threaten Ireland’s economic rights as an EU member and it will be unacceptable by the 26 EU member states. Without a border, animal and plant products will enter the EU single market, without full legal controls. Ireland’s goods won’t be trusted, and checks will possibly be required in order to enter the EU. Markets will await any updates on Friday, following the EU and UK's chief negotiators meeting this week.

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The pound has fallen since last week’s Bank of England (BoE) monetary policy decision to leave the Bank rate unchanged at 0.10%. While it is expected to stabilise the following days, analysts do not anticipate considerable gains for the pound in the near term.

The BoE’s decision to keep monetary policy unchanged took markets by surprise but it chimed with members of the Monetary Policy Committee comments that the Bank wanted to wait and see further evidence about the state of the economy and the health of the labour market, especially the impact of the furlough scheme which ended in September. Analysts still expect a February rate increase instead of one in December.

Possible interest rate rise

The BoE wants to wait and analyse the impact that the end of the furlough scheme will have on the economy, and employment in particular, before making any decisions on raising interest rates. Some of the data will become available in December and more later in January and February. This is why the November interest rate rise was too soon, whereas other ones in December, February 2022 or some time later, appear to be more likely possibilities.

Before the next Bank of England meeting on the 16th of December, analysts and policymakers will have the chance to examine two jobs reports and two inflation reports, which will determine how the Bank will act if there is to be a 15bp December hike. Since markets have not yet priced in a December move, there could be potential for Sterling to rise.

Pound outlook

Analysts believe that there is still potential for the pound as markets digest the news and adjust to a less aggressive policy response in the next meetings.

At the same time, for inflation to return to a target that will be within expectations, the Bank rate will need to rise. The Governor of the Bank of England, Andrew Bailey, said that the BoE would not raise rates to 1 per cent by the end of 2022, because according to the bank’s forecasts inflation would fall below its 2 per cent target in the medium term if they tightened monetary policy too much. Higher inflation is expected to be transitory, leading to an increase in consumer prices, which would have been higher if interest rates rose even a little. The Bank, however, does not expect inflation to fall below 3 per cent until the spring of 2023, which means there will be a period of higher inflation.

Brexit

Brexit is adding some pressure on the pound at the beginning of this week, as reports that the UK is preparing to trigger Article 16 of the Northern Ireland Protocol are growing. Senior Government and EU figures have held discussions to prepare on the possibility of the UK triggering article 16 of the Northern Ireland protocol, a move that both Dublin and Brussels expect in the coming weeks. The move could create a crisis in EU-UK relations. Minister for Foreign Affairs Simon Coveney said that the EU could retaliate by withdrawing the entire free trade and co-operation agreement, reigniting fears of a “no-deal Brexit” and tariffs on trade.

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